Company D has a 50 percent debt ratio, whereas Company E has no debt financing. The two companies have the same level of sales, and the same degree of operating leverage. Which of the following statements is most correct?
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A. B. C. D. E.E
After the sales increase, the percentage increase in EBIT will be the same for both companies. Company E's net income will rise by exactly 10%.
To determine the correct statement, let's analyze the given information:
Let's evaluate each answer choice to find the correct statement:
A. None of these answers are correct. This option implies that none of the answer choices accurately describe the situation. We'll assess the other options to determine if any of them are correct.
B. If sales increase 10 percent for both companies, then Company D will have a larger percentage increase in its operating income (EBIT). This statement may or may not be correct. Operating income (EBIT) is affected by sales and the degree of operating leverage. Since both companies have the same degree of operating leverage, the increase in operating income would depend on the magnitude of the change in sales and the specific cost structure of each company.
C. All of these answers are correct. This option states that all the answer choices are correct, which cannot be true since option A is incorrect. Therefore, option C is incorrect.
D. If EBIT increases 10 percent for both companies, then Company D's net income will rise by more than 10 percent, while Company E's net income will rise by less than 10 percent. This statement is incorrect. Net income is affected by interest expense (due to the debt ratio) and taxes, in addition to operating income. Since Company E has no debt financing, it will not have interest expense, resulting in its net income increasing by the same percentage as its operating income, which is 10 percent in this case. Company D, however, will have interest expense due to its debt financing, which will reduce its net income increase compared to its operating income increase. Therefore, Company D's net income increase will be less than 10 percent.
E. If sales increase 10 percent for both companies, then Company D will have a larger percentage increase in its net income. This statement may or may not be correct. The debt ratio does not directly affect the percentage increase in net income when sales increase. It depends on various factors such as cost structure, operating leverage, interest expense, and taxes.
Based on the analysis, the correct answer is D. If EBIT increases 10 percent for both companies, then Company D's net income will rise by more than 10 percent, while Company E's net income will rise by less than 10 percent.