The increase in risk to equityholders when financial leverage is introduced is evidenced by:
A)higher EPS as EBIT increases.
B)a higher variability of EPS with debt than all equity.
C)increased use of homemade leverage.
D)equivalence value between levered and unlevered firms in the presence of taxes.
E)None of the above.

Question

Quizplus · Accepted Answer

When financial leverage is introduced, the variability of EPS increases as a result of interest expense and the fixed nature of debt payments. This means that equityholders face greater risk as their returns become more unpredictable. Choice A is incorrect because higher EPS as EBIT increases does not necessarily indicate an increase in risk to equityholders. Choice C is incorrect because the use of homemade leverage (taking on personal debt to offset the effects of corporate leverage) does not necessarily affect the increased risk to equityholders. Choice D is incorrect because equivalence between levered and unlevered firms only holds in the context of taxes and the presence of other assumptions, and it does not directly indicate increased risk to equityholders. Choice E is incorrect because there is a clear increase in risk to equityholders with the introduction of financial leverage.

The Increase in Risk to Equityholders When Financial Leverage Is