Measures of Leverage

[archived_user]

[question removed by moderator]
This is a question in Institute end of the chapter qs. I had a doubt as to why isn’t Option A correct, because as debt increase Net income decreases so sensitivity of net income to changes in unit sales of Grundlegend must be lower.
Can anyone please help me out.

 

[archived_user]

A is incorrect as there’s no reason of company G to have a lower sensitivity in sales.

 

[archived_user]

That is lower sensitivity of net income to sales which means Financial leverage. As debt increases, NI falls, so should the numerator, shouldn’t it?

 

[archived_user]

To solve this question, lets go through the basics:

1. higher leverage results in higher sensitivity
2. total leverage is a product of operating leverage and financial leverage
3. operating leverage is % change in operating income divided by % change in units sold
4. financial leverage is % change in net income divided by % change in operating income
5. total leverage is therefore % change in net income divided by % change in units sold

After reviewing the above bullets, particularly #2 & 5, and information in the question, it is evident that Grundlegend has a relatively higher financial leverage. Higher financial leverage translates into higher total leverage which results in higher sensitivity. And that’s the reason why Option A is incorrect. Hope it clears!

 

[archived_user]

Why is the Financial leverage higher? As the Debt increases so the Net Income falls so the % change in Net Income will be lower right?
Please elaborate.