EPS Sensitivity to EBIT - Test Prep

Which Firm's Earnings per Share (EPS) is Least Sensitive to EBIT?

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Question

Which of the following firm's earnings per share (EPS) figure would be least sensitive to a percentage change in Earnings Before Interest and Taxes (EBIT)?

Firm A -

EBIT: $6,800,000 -

Interest Paid: $505,000 -

Total Operating Expenses: $80,000,000

Fixed Operating Expenses: $50,250,000

Firm B -

EBIT: $20,000,000 -

Interest Paid: $600,000 -

Total Operating Expenses: $40,000,000

Fixed Operating Expenses: $30,250,000

Firm C -

EBIT: $50,500,000 -

Interest Paid: $3,500,000 -

Total Operating Expenses: $66,000,000

Fixed Operating Expenses: $30,750,000

Firm D -

EBIT: $49,700,000 -

Interest Paid: $7,750,000 -

Total Operating Expenses: $90,000,000

Fixed Operating Expenses: $75,000,000

Firm E -

EBIT: $43,000,000 -

Interest Paid: $7,000,000 -

Total Operating Expenses: $85,000,000

Fixed Operating Expenses: $60,500,000

Answers

Explanations

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A. B. C. D. E. F.

B

This question is asking you to calculate the Degree of Financial Leverage for each company. The Degree of Financial Leverage (DFL) measures the percentage change in EPS that results from a given percentage change in EBIT. Financial Leverage is the second component of total leverage, along with Operating

Leverage. The equation used to calculate the Degree of Financial Leverage is as follows: {DFL = [EBIT/(EBIT - Interest Paid)]}. As companies incorporate more debt in their capital structure, their EPS figure will become more sensitive to fluctuations occurring from interest payments, and this is evidenced by an increase in the Degree of Financial Leverage. In this example, Firm B has the lowest DFL with a figure of 1.031. In light of this information, it can be concluded that firm B has an EPS figure which is the least sensitive to a given change in EBIT. When calculating the DFL figure, remember that the answer can never be less than one, and can never be negative. In a situation where the company under examination has zero debt, and no preferred stock dividends (and therefore no interest expense for purposes of the DFL equation), the DFL would be equal to one. It is important note to remember is that in calculating the Degree of Financial Leverage, dividend payments to preferred stockholders should be included in the interest expense figure. Operating expenses are not factored into the DFL calculation, rather are used in the determination of Operating Leverage.

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