Question

When comparing levered vs. unlevered capital structures, leverage works to increase EPS for high levels of EBIT because: A. interest payments on the debt vary with EBIT levels. B. interest payments on the debt stay fixed, leaving less income to be distributed over less shares. C. interest payments on the debt stay fixed, leaving more income to be distributed over less shares. D. interest payments on the debt stay fixed, leaving less income to be distributed over more shares. E. interest payments on the debt stay fixed, leaving more income to be distributed over more shares.

Answer 1

Answer: C. interest payments on the debt stay fixed, leaving more income to be distributed over less shares.

Explanation:

When the Earnings Before Interest and Taxes (EBIT) is higher, it means that after the interest payment (which is a fixed amount) has been deducted, there will be more income going to shareholders.

It is important to note that when there is leverage, there will be less shares than in the case of no leverage because no leverage would require more shares for adequate financing. Leverage does not require as much shares so the income left after interest payment deductions will therefore go to less shares.