Company D has a 50% debt ratio,whereas Company E has no debt financing.The two companies have the same level of sales and the same degree of operating leverage.Which of the following statements is most CORRECT?
A)If sales increase 10% for both companies, then Company D will have a larger percentage increase in its net income.
B)If sales increase 10% for both companies, then Company D will have a larger percentage increase in its operating income (EBIT).
C)If EBIT increases 10% for both companies, then Company D's net income will rise by more than 10%, while Company E's net income will rise by less than 10%.
D)Company E has a higher degree of financial leverage.
E)The two companies have the same degree of total leverage.

Question

Quizplus · Accepted Answer

Company D has debt financing, which means it has interest expense, and therefore a portion of its operating income goes towards paying off interest on its debt. This lowers its net income compared to Company E, which has no interest expense. However, because Company D has some debt financing, it has some financial leverage - this means that for a given percentage increase in sales, Company D will experience a larger percentage increase in its net income compared to Company E. So if sales increase 10% for both companies, then Company D will have a larger percentage increase in its net income.

Company D Has a 50% Debt Ratio,whereas Company E Has