If a firm uses debt financing (Debt ratio = 0.40)and sales change from the current level,which of the following statements is CORRECT?
A)The percentage change in operating income (EBIT) resulting from the change in sales will exceed the percentage change in net income.
B)The percentage change in EBIT will equal the percentage change in net income.
C)The percentage change in net income relative to the percentage change in sales (and in EBIT) will not depend on the interest rate paid on the debt.
D)The percentage change in operating income will be less than the percentage change in net income.
E)Since debt is used, the degree of operating leverage must be greater than 1.

Question

Quizplus · Accepted Answer

When a firm uses debt financing, it has fixed interest payments to make which reduces net income. Therefore, the percentage change in operating income (EBIT) resulting from the change in sales will be higher than the percentage change in net income. This means the percentage change in operating income will be greater than the percentage change in net income. Therefore, option D is correct. The answer to option A is incorrect because the percentage change in operating income will be higher than the percentage change in net income. Option B is incorrect because of the fixed interest payments. Option C is incorrect because the interest rate paid on debt financing will affect the percentage change in net income. Option E is incorrect as the degree of operating leverage depends on fixed costs, not on the use of debt financing.

If a Firm Uses Debt Financing (Debt Ratio = 0