- CFA Exams
- CFA Level I Exam
- Study Session 11. Corporate Finance (2)
- Reading 34. Measures of Leverage
- Subject 2. Financial Risk and Financial Leverage

###
**CFA Practice Question**

A firm's cost of equity is 12%, which reflects a 4% premium over the cost of its long-term debt. The firm has an EBIT of $27,900 and $65,000 in debt. The firm is planning to increase its debt by $15,000, which will raise the cost of debt by 1% for the additional amount. What is the change in the company's pre-tax profit due to the additional debt?

A. -8.81%

B. -5.95%

C. -5.29%

**Explanation:**Cost of debt = Cost of equity - Risk premium = 12 - 4 = 8%

Current PBT = 27,900 - 0.08 x 65,000 = 27,900 - 5,200 = 22,700

Cost of additional 15,000 in debt is 9% (= 8 + 1).

New PBT = 27,900 - 0.08 x 65,000 - 0.09 x 15,000 = 27,900 - 6,550 = 21,350

Change in PBT = (21,350 - 22,700) / 22,700 = -0.0595, or -5.95%

###
**User Contributed Comments**
12

User |
Comment |
---|---|

iceluke |
first the profit before tax, then everything else should be clear |

linr0002 |
additional amount is at 9% not full amt |

Bibhu |
PBT - Profit before tax. |

ksnider |
when calculating the new PBT dont you need to use the new debt level of 80,000 (65,000 + 15,000)?? if so you'd get -8.81% as the answer. can someone explain why you wouldn't use 80K? |

Boubena |
The new debt level is already used but at different rates: 8% for 65K and 9% for 15 K. |

gill15 |
I would put this in the difficult section. Not crazy hard but I would not have got it without the solution. |

SKIA |
Agree with Gill15 |

chris297 |
"1% for additional amount" has too many implications. |

CJPerugini |
^Agreed. |

atlootah |
how did we get the 1% ?? |

atlootah |
nvm |

Albireo |
Can someone please explain this in a simpler way? I don't understand it. What's throwing me off is how we calculate the new profit (and why we do it in such a way!). |