Capital Structure and Leverage: Financial Leverage, EBIT–EPS Analysis (Basics) Questions

Question 1

Define capital structure.

Accepted Answer

Capital structure is the mix of **long-term debt and equity** used to finance the company (concept).

Question 2

What is leverage?

Accepted Answer

Leverage means using **fixed costs** (operating or financial) to magnify results like profit or EPS (concept).

Question 3

Define financial leverage.

Accepted Answer

Financial leverage is the use of **debt** (fixed interest) in financing, which affects EPS (concept).

Question 4

EBIT means earnings before interest and tax. (True/False)

Accepted Answer

True. **EBIT** is earnings before interest and tax (concept).

Question 5

State one advantage of using debt in capital structure (concept).

Accepted Answer

Debt can increase **EPS** through financial leverage when earnings are strong (concept).

Question 6

State one disadvantage of using too much debt (concept).

Accepted Answer

High debt increases **financial risk** due to fixed interest obligations (concept).

Question 7

Differentiate operating leverage and financial leverage using a table (any three points).

Accepted Answer

Operating vs financial leverage:

| Basis | **Operating leverage** | **Financial leverage** |
|---|---|---|
| Fixed element | fixed operating costs | fixed **interest** |
| Magnifies | sales → EBIT | EBIT → EPS |
| Main risk | business/operating risk | financial risk (default risk) |

Thus, operating leverage comes from operations, while financial leverage comes from financing.

Question 8

List types of leverage and state what each one magnifies using a table.

Accepted Answer

Types of leverage:

| Type | Fixed element | Magnifies (concept) |
|---|---|---|
| **Operating** | fixed operating cost | sales → EBIT |
| **Financial** | fixed interest | EBIT → EPS |
| **Combined** | both | sales → EPS |

This table is a standard exam answer.

Question 9

Explain EBIT–EPS analysis (meaning + use) in 3 points and add a simple flow.

Accepted Answer

EBIT–EPS analysis (concept):

- compares financing plans (more debt vs more equity)
- computes **EPS** at different EBIT levels
- helps choose the plan that gives better EPS at expected EBIT

Flow: Choose plans → take EBIT levels → subtract interest → compute EAT → compute **EPS** → compare and decide

Question 10

Show the effect of debt on EPS (concept) using a small table and conclusion (brief).

Accepted Answer

Effect of debt (concept):

| Situation | Debt effect on **EPS** |
|---|---|
| High EBIT | may increase EPS (leverage benefit) |
| Low EBIT | may decrease EPS (interest burden) |

Conclusion: debt magnifies outcomes—higher potential return but higher risk.

Question 11

Differentiate capital structure and financial structure (any three points) using a table.

Accepted Answer

Capital structure vs financial structure:

| Basis | **Capital structure** | **Financial structure** |
|---|---|---|
| Coverage | long-term funds (debt + equity) | all funds (long-term + short-term) |
| Includes | equity, long-term debt, preference (concept) | includes current liabilities also (concept) |
| Focus | long-term financing mix | overall financing pattern |

Thus, capital structure is a part of the broader financial structure.

Question 12

List any three factors that increase financial risk in a company (concept) using points/table.

Accepted Answer

Factors increasing **financial risk** (any three) (concept):

- higher **debt** level (fixed interest burden)
- unstable cash flows/low EBIT levels
- high fixed commitments (interest + principal repayments) (concept)
- poor liquidity and weak interest coverage (concept)

Any three points with brief explanation are sufficient.

Question 13

Write an exam-style answer on capital structure: meaning, factors affecting it, and conclusion (include a table).

Accepted Answer

### Meaning
**Capital structure** is the long-term mix of debt and equity.

### Factors (concept)
| Factor | Effect |
|---|---|
| Business risk | higher risk → prefer lower debt |
| Cost of debt vs equity | cheaper debt may be used more (concept) |
| Cash flow stability | stable cash flows can support debt |
| Control considerations | issuing equity may dilute control (concept) |

### Conclusion
An optimal capital structure balances **return** and **risk** by choosing an appropriate debt–equity mix (concept).

Question 14

Explain financial leverage: meaning, merits and demerits (exam-style) with a table and conclusion.

Accepted Answer

### Meaning
**Financial leverage** arises when debt with fixed interest is used.

| Merits | Demerits |
|---|---|
| may increase **EPS** when EBIT is strong (concept) | increases **financial risk** due to fixed interest |
| possible tax benefit on interest (concept) | risk of default in low EBIT periods |
| can improve return to equity in good times | reduced flexibility/creditworthiness (concept) |

### Conclusion
Debt can improve returns but also increases risk; therefore leverage should be used carefully (concept).

Question 15

Write an exam-style note on EBIT–EPS analysis with steps and conclusion (include a flowchart/table).

Accepted Answer

### Meaning
EBIT–EPS analysis compares financing plans by checking how **EPS** changes at different EBIT levels.

### Steps (flow)
Select plans (debt/equity mix) → Choose EBIT levels → Subtract interest (if any) → Compute EBT/EAT (concept) → Divide by number of shares → Compare EPS → Choose plan

| Plan | Typical feature |
|---|---|
| Equity-heavy | low risk, stable EPS |
| Debt-heavy | higher EPS at high EBIT, higher risk at low EBIT |

### Conclusion
EBIT–EPS analysis helps select a financing plan consistent with expected EBIT and risk tolerance.

Basis	Operating leverage	Financial leverage
Fixed element	fixed operating costs	fixed interest
Magnifies	sales → EBIT	EBIT → EPS
Main risk	business/operating risk	financial risk (default risk)

Capital Structure and Leverage: Financial Leverage, EBIT–EPS Analysis (Basics)

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