Question

When comparing levered vs. unlevered capital structures, leverage works to increase EPS for higher levels of operating income because interest payments on the debt:

A) Decrease the taxable income
B) Are tax-deductible
C) Are higher for unlevered structures
D) Depend on the corporate tax rate

Answer 1

Leverage increases EPS for higher levels of operating income because interest payments on debt are tax-deductible, lowering taxable income which can increase net income and EPS. Option B is correct.

Step-by-step explanation:

When comparing levered vs. unlevered capital structures, leverage works to increase EPS (earnings per share) for higher levels of operating income because interest payments on the debt are tax-deductible. This means that taking on debt can lower a firm's taxable income due to the deduction of interest payments, thus increasing net income and potentially earnings per share for the shareholders. However, it's important to remember that this only works to the firm's advantage when there is sufficient operating income to cover the interest payments. Otherwise, the cost of debt could outweigh its benefits.