 # Leverage Q

An increase in financial leverage will cause a price-to-earnings (P/E) multiple to: A) increase. B) remain the same. C) there is insufficient information to tell. D) decrease T/G

All other things equal, a high Degree of Financial Leverage will result in a higher EPS. Subsequently, the denominator of P/E will rise, decreasing P/E. So D.

Insufficient info really… but I doubt thats the ans… An increase in Leverage will increase ROE And increase in ROE will increase g Using P/E = (1-b)/(r-g) we get an decrease in the denominator and this should increase P/E… therefore A

chadtap I had the same thinking… Your answer: A was incorrect. The correct answer was D) decrease. An increase in financial leverage will cause the required rate of return to increase, thereby decreasing the P/E. This is clear in the expression for trailing P/E: P0 / E0 = [(1 – b)(1 + g)] / (r – g) (Note: the reading does not allow for any interactive relationship between leverage, return on equity (ROE), and growth. Thus, no explicit consideration is given to whether the increase in leverage would increase ROE and therefore growth through the g = (ROE × retention) relationship.) T/G

ChicagoPMA Wrote: ------------------------------------------------------- > All other things equal, a high Degree of Financial > Leverage will result in a higher EPS. > Subsequently, the denominator of P/E will rise, > decreasing P/E. > > So D. That’s assuming positive EPS. I would have gone with not sufficient information. These questions seems like a toss up almost every time.

cheap question… you would think then the ans. should be C…

Yeah, we had a debate on this the other day. Pretty ridiculous question. I don’t think they would ask a question like this on the exam. I feel like this is a question that schweser creates to test your knowledge on that specific forumula.