Assume you are reviewing a graph depicting earnings per share (EPS) on the verti

Question

Assume you are reviewing a graph depicting earnings per share (EPS) on the vertical axis and earnings before interest (EBI) on the horizontal axis. Data points for both a levered and an unlevered firm are displayed. Given this, which statement accurately describes this graph?

The unlevered firm has a greater reaction to a change in EBI than does the levered firm.

Debt becomes a greater disadvantage to a firm as EBI increases.

When earnings exceed the breakeven point, the levered firm has the higher EPS.

Both the levered and unlevered firms have zero EPS when EBI is zero.

The levered firm consistently has higher EPS than the unlevered firm.

Explanation / Answer

Assume you are reviewing a graph depicting earnings per share (EPS) on the vertical axis and earnings before interest (EBI) on the horizontal axis. Data points for both a levered and an unlevered firm are displayed. Given this, which statement accurately describes this graph?

CORRECT ANSWER : When earnings exceed the breakeven point, the levered firm has the higher EPS.

EXPLANATION:

AS EBI INCREASES, THE EPS INCREASES FOR LEVERED FIRM. SO LEVERED FIRM IS MORE SENSITIVE TO CHANGE IN EBI

DEBT IS ADVANTAGEOUS FOR LEVERED FIRM AS EBI INCREASES, BECAUSE ONCE PAID FOR INTEREST, WHATEVER EARNINGS ARE LEFT ARE OF EQUITY SHAREHOLDERS ONLY, SO IT INCREASES THE EPS

UNLEVERED FIRM HAS NO DEBT SO WHEN EBI= ZERO, IT WILL HAVE ZERO EPS BUT LEVERED FIRM HAS DEBT, SO ITS EPS WILL BE NEGATIVE.

BEFORE BEP, THE LEVERED FIRM HAS LOWER EPS THAN UNLEVERED FIRM. AFTER BEP, THE LEVERED FIRM EPS IS HIGHER THAN UNLEVERED FIRM

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