Question

Which of the following statements is CORRECT? If a company were to issue debt and use the money to repurchase common stock, this action would have no impact on the company's return on assets. (Assume that the repurchase has no impact on the company's operating income.) The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes share price. Increasing financial leverage is one way to increase a firm's basic earning power (BEP). Firms with lower fixed costs tend to have greater operating leverage. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation.

Answer 1

The correct answer is Option-C: Increasing financial leverage is one way to increase a firm's basic earning power.

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Reason:

Use of fixed cost bearing capital in the capital structure is termed as financial leverage. Such capital, especially debt is cheaper than the equity as the cost of debt is generally lower than that of equity and a tax advantage is attached with its use. In this circumstances, if total capital employed remains constant, increase in financial leverage or use of debt implies that a relatively cheaper source of fund replaces a source of fund having relatively higher cost. Now if company follows this practice its net return will be attributable to the low base of equity share holders (lower base being due to the increase in financial leverage). As a result it will lead to magnification of return to the equity and thus EPS.

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