CFA Practice Question
If a firm uses debt financing (Debt ratio = 0.40) and sales change from the current level, which of the following statements is most correct?
A. 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.
B. The percentage change in net operating income (EBIT) resulting from the change in sales will exceed the percentage change in net income (NI).
C. The percentage change in net operating income will be less than the percentage change in net income.
Explanation: The greater the use of fixed assets, the more sensitive EBIT will be to changes in sales. Interest charges on debt are included in net income and not operating income, as the use of debt financing will have an impact on net income when sales change.
User Contributed Comments 10
| User | Comment |
|---|---|
| eddeb | I don't see Operating Leverage here, but Financial leverage... Can anyone help? |
| Dancho | The greater the fixed assets, operating levarage increase. The idea here is that interest expenses do not impact EBIT. |
| volkovv | think of simple example: you have sales=100 and 0 expenses; then EBIT=100; say interest=20; NI=80 now say sales go up by 10%, new sales=110; new EBIT=110; interest stays the same=20; new NI=90; change in NI=90/80-1=12.5% but change in EBIT is 110/100-1=10% |
| Analizer | Volkov, great explanation. Thanks |
| grezavi | But volkow you are assuming that if new sales is 10& then EBIT will increase by 10%, that is not possible, don't forget COGS if EBIT had gone up by 5% the answer would have been reversed |
| capitalpirate | he assumed expenses=0 to simplify... |
| Khatija | thanks for the explanation volkovv. It was very helpful! |
| mixer | thanx VOLKOV helpful |
| nfressell2 | What if sales decreased? The opposite is true |
| nfressell2 | Absolute value change I suppose would make the answer choice better |