Canadian Securities Course (CSC) Level 2 Practice Exam

What is the main purpose of leverage in company analysis and how does it affect revenues and EPS when capital structure contains debt or preferred shares?

1. If capital structure contains debt or preferred shares, it will decelerate cyclical rise and fall compared to industry

2. If capital structure contains debt or preferred shares, it will accelerate cyclical rise and fall but remains steady compared to industry (INCREASE revenues and EPS)

3. If capital structure contains debt or preferred shares, it has no impact on cyclical rise and fall

4. If capital structure contains debt or preferred shares, it leads to a gradual decline in revenues and EPS over time

The correct answer is: If capital structure contains debt or preferred shares, it will accelerate cyclical rise and fall but remains steady compared to industry (INCREASE revenues and EPS)

The correct answer emphasizes that when a company's capital structure includes debt or preferred shares, leverage can enhance the potential for revenue and earnings per share (EPS) growth, particularly during favorable economic conditions or periods of increased demand. This is because debt financing, when used effectively, can amplify returns. When a company uses leverage, it retains a greater portion of its earnings after covering fixed interest costs, which can lead to higher EPS as revenues increase. High fixed costs associated with debt or preferred shares do impose some risks, particularly during downturns, but during upswings, the potential for profit growth can be significantly accelerated. This aspect underlines the concept that leverage magnifies both gains and losses, leading to more pronounced cyclical fluctuations compared to a more conservatively financed firm. The assertion that leverage can decelerate the cyclical rise and fall does not accurately capture the essence of how leverage generally functions in financial analysis. Saying leverage has no impact contradicts fundamental principles of finance since capital structure inherently shapes the risk and return profile of a company. Furthermore, suggesting that leverage leads to a gradual decline in revenues and EPS over time overlooks the capacity for companies to utilize debt strategically to fund growth and improve profitability in favorable conditions.