[Harry]

Which of the following is accurate regarding a company with high degree of financial leverage and significant losses for the period?

A. Common stockholders are better off than they would have been if the firm was not as heavily leveraged.
B. Common stockholders are worse off than they would have been if the firm was not as heavily leveraged.

I think the answer is A but I don’t know why my testbank shows answer is B.
Does anyone agree my answer or am I wrong? Can anyone explain please?

[CPAIN2K17]

Financial leverage means they finance with debt more, and debtors get payment first. So, the common stockholders are worse off because they will not get payment until debtors have been paid. If the firm wasn't as highly leveraged (had less debt), the common stockholders would be better off, because they would be more likely to receive payment.

[Anonymous]

I think the answer is B.
DFL = EBIT/EBIT-INT
SO if Int is high, the denominator will be lower as a result of which DFL will be higher.
So if a firm has losses, the interest expense increases those losses.
If the firm was not so heavily leveraged the interest expense would be lower which would mean a bigger portion of income available to the shareholders.

I hope this helps

[Harry]

CPA2K17,

Thank you for your help, so as your explaination you agree my answer which should be A, right? The company had losses, it means shareholders are better off when the company is not highly leveraged. Because the higher degree of financial leverage the worse for shareholders when company operate bad. On the other hand, the higher degree of financial leverage the better for shareholders when company operates well.

[Harry]

AMREEN,

Thank you for your help, as you mentioned when DFL is high and there is loss, high DFL lead higher loss. Is it what you said right?
So if this is the case why the answer should not be A which is common share holders are better off than they would have been if the company was not as heavily leveraged. Because the more heavily leveraged the worse for shareholders when there is loss, am I wrong?

[Anonymous]

Harry Kim i think you are interpreting the answer choices incorrectly.
A. Common stockholders are better off than they would have been if the firm was not as heavily leveraged.
Explanation: This answer choice suggests that the shareholders are better off NOW. i.e. they are better off now with the high DFL than they would have been if the firm had a low DFL.

B. Common stockholders are worse off than they would have been if the firm was not as heavily leveraged.
Explanation: This answer choice suggests that the stockholders are worse of now because of the high DFL and would be better off had the DFL were lower.

Thus, if DFL had been lower then the interest would have lower. As a result of this the loss would have been lower or maybe there would have been no loss at all (depending on what caused the loss). Assuming the high interest caused the loss, a lower DFL would have resulted in a lower interest expense which would increase the earnings available for distribution to the shareholders, thus making the shareholder better off with a lower degree of financial leverage.

[Harry]

Amreen,

Oh, yeah you are right,I interpreted the answer wrong..
Now answer B makes sense to me. Thank you so much for your time and help Amreen!

[CPAIN2K17]

No I was not agreeing that A is correct haha. The common shareholders are better off if there is LESS debt = not highly leveraged. The common shareholders are worse off if there is MORE debt = highly leveraged.

[Author]

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