CFA Practice Question

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CFA Practice Question

When comparing levered vs. unlevered capital structures, leverage works to increase EPS for high levels of operating income because interest payments on the debt ______

A. vary with EBIT levels.
B. stay fixed leaving less income to be distributed over fewer shares.
C. stay fixed, leaving more income to be distributed over fewer shares.
D. stay fixed, leaving less income to be distributed over more shares
E. stay fixed, leaving more income to be distributed over more shares.
Correct Answer: C

User Contributed Comments 6

User Comment
Gina why less shares? I thought there would be more shares since the levered firm might issue convertibles??
tony1973 if a company uses leverage, it issues less shares given a fixed amount of total assets.
setmefree more income is relative to a low EBIT; imagine the only purpose of issueing bond is to change capital structure (rather than to finance a positive NPV project), so debt is used to buy back outstanding shares,and share price should remain the same since there's no good/bad news. so EPS is higher
setmefree but the interest payments reduce EBIT, and could reduce EPS! however in this question, the only appropriate answer seems to be C, since it sure will result a higher EPS.
steved333 Interest payments may reduce EPS, but the higher the level of income, the more negligible that reduction becomes, as the interest levels are fixed. Since leverage is used in place of issuing shares, there are fewer shares than there would be if the company used more equity in its capital structure. Therefore, a leveraged company has fewer shares to spread the earnings over. Therefore, C.
Shaan23 I agree with the less shares part but not the more income part. A company with leverage will show lower net income compared to a company with higher income.

Look at the chart in the textbook that compares an unlevered company to a levered one. The NI is lower for the levered company.
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