Question

If a firm utilizes debt financing, a 10% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than 10%, and the higher the debt ratio, the larger this difference will be.
True or False?

Answer 1

Answer:

True

Explanation:

It is easier to explain following an example:

EBIT 100

debt interests 25

shares outstanding 500

                            No change scenario      -10% EBIT          +10% EBIT

EBIT                              100                              90                       110

interests                       (25)                             (25)                      (25)    

net income                    75                               65                        85

earnings per share      0.15                            0.13                      0.17

change                           -                              -13.3%                  +13.3%

A 10% EBIT decrease will result in a 13.3% decrease in earnings per share, while a 10% EBIT increase will result in a 13.3% increase in earnings per share.