LOS d: Describe the effect of financial leverage on a company's net income and return on equity.

If a firm is financed with 100% equity, there is a direct relationship between changes in the firm’s ROE and changes in operating income. Adding financial leverage (debt) to the firm’s capital structure will cause ROE to become much more volatile and ROE will change more rapidly for a given change in operating income. The increased volatility in ROE reflects an increase in both risk and potential return for equity holders. Note that financial leverage results in increased default risk, but since existing bond holders are compensated by coupon interest and return of principal, their potential return is unchanged. Although financial leverage will generally increase ROE if a firm has a positive operating margin (EBIT/Sales), if the operating margin were small, the added interest expense could turn the firm’s net profit margin negative, which would in turn make ROE negative.

You should be able to figure out this question with logic (without having to use calculations). The interest expense associated with using debt represents a fixed cost that reduces net income. However, the lower net income value is spread over a smaller base of equity capital, serving to increase the ROE.

Bath & Books appears to have relatively little business risk, especially in relation to Egg Harbor Furs, which is likely to be a much more cyclical business. Creditors will be less willing to lend funds to Critter Care whose managers have shown poor money management skills in the past.