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

Q1. Which of the following statements regarding the impact of financial leverage on a company’s net income and return on equity (ROE) is most accurate?

A)   If a firm has a positive operating profit margin, using financial leverage will always increase ROE.

B)   Using financial leverage increases the volatility of ROE for a level of volatility in operating income.

C)   Increasing financial leverage increases both risk and potential return of existing bondholders.

Q2. Munn Industrial Components currently finances its operations with 100% equity, but is considering changing its target capital structure to 70% equity and 30% debt. Munn has a large asset base, a 20% operating profit margin, and the average interest rate on debt is expected to be 6.0%. If Munn makes the change to its capital structure and EBIT is unchanged, what is most likely the impact on Munn’s net income and return on equity (ROE) respectively?

          Impact on Net Income                 Impact on Return on Equity

A)   No Change                                           Increase

B)   Decrease                                              Increase

C)    Decrease                                            Decrease

LOS e: Describe the effect of financial leverage on a company's net income and return on equity. fficeffice" />

Q1. Which of the following statements regarding the impact of financial leverage on a company’s net income and return on equity (ROE) is most accurate?

A)   If a firm has a positive operating profit margin, using financial leverage will always increase ROE.

B)   Using financial leverage increases the volatility of ROE for a level of volatility in operating income.

C)   Increasing financial leverage increases both risk and potential return of existing bondholders.

Correct answer is B)

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.

Q2. Munn Industrial Components currently finances its operations with 100% equity, but is considering changing its target capital structure to 70% equity and 30% debt. Munn has a large asset base, a 20% operating profit margin, and the average interest rate on debt is expected to be 6.0%. If Munn makes the change to its capital structure and EBIT is unchanged, what is most likely the impact on Munn’s net income and return on equity (ROE) respectively?

          Impact on Net Income                 Impact on Return on Equity

A)   No Change                                           Increase

B)   Decrease                                              Increase

C)    Decrease                                            Decrease

Correct answer is B)

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.

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