You are comparing two financial policies:

First policy: All equity.

Second policy: this policy involves the use of $2 million of debt.

The break-even point between these two policies occurs when the earnings before interest and taxes (EBIT) is $1,250,000. Given this, it is accurate to say that the increased use of debt (leverage)_____ beneficial to the firm when EBIT is $1,325,000 and _____ beneficial when EBIT is $625,000.

Question

You are comparing two financial policies:

First policy: All equity.

Second policy: this policy involves the use of $2 million of debt.

The break-even point between these two policies occurs when the earnings before interest and taxes (EBIT) is $1,250,000. Given this, it is accurate to say that the increased use of debt (leverage)_____ beneficial to the firm when EBIT is $1,325,000 and _____ beneficial when EBIT is $625,000.

BlackTom AI · Accepted Answer

We begin by restating the scenario and the goal of the question. The break-even EBIT between the two policies is 1,250,000. If EBIT is above this point, leverage tends to increase earnings per share (EPS) and be beneficial; if EBIT is below this point, leverage tends to decrease EPS and be not beneficial. Now, evaluate each option in turn.

Option 1: 'is not; is'
- This option asserts that the increased use of debt is not beneficial when EBIT is 1,325,000 (which is above break-even) and is beneficial when EBIT is 625,000 (which is below break-even).
- The statement conflicts with the break-even logic: above break-even, debt financing typically increases EPS; below break-even, debt financing typically reduces EPS. Therefore, this option misstates the relationship on both sides and is incorrect.

Option 2: 'is not; is not'
- This option claims leverage is not beneficial at EBIT 1,325,000 and also not beneficial at EBIT 625,000.
- While the first claim contradicts the expected benefit above break-even, the second claim aligns with the idea that leverage is not beneficial below break-even. However, because the first part is incorrect, the entire option is invalid.

Option 3: 'is; is not'
- Here, the claim is that leverage is beneficial (is) when EBIT is 1,325,000 (above break-even), and not beneficial (is not) when EBIT is 625,000 (below break-even).
- This aligns with the standard interpretation of leverage: above break-even EBIT, the debt increases the tax shield and EPS, making leverage beneficial; below break-even, the fixed interest costs erode EPS, making leverage not beneficial. This option is consistent with the break-even concept and the financial effect of leverage.

Option 4: 'is; is'
- This option states leverage is beneficial in both scenarios: EBIT 1,325,000 and EBIT 625,000.
- The above-break-even scenario would indeed be beneficial, but the below-break-even scenario would not typically be beneficial due to the fixed interest expense. Therefore, this option mischaracterizes the impact at the lower EBIT level and is incorrect.

In summary, each option was assessed against the break-even point and the standard effect of leverage on EPS across EBIT levels. The only option that coherently matches the expected behavior—beneficial when EBIT exceeds break-even and not beneficial when EBIT falls short—is the one stating 'is; is not' for the two EBIT values.

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