Measures of Leverage

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This is a question in Institute end of the chapter qs. I had a doubt as to why isn’t Option A correct, because as debt increase Net income decreases so sensitivity of net income to changes in unit sales of Grundlegend must be lower. Can anyone please help me out.

A is incorrect as there’s no reason of company G to have a lower sensitivity in sales.

That is lower sensitivity of net income to sales which means Financial leverage. As debt increases, NI falls, so should the numerator, shouldn’t it?

To solve this question, lets go through the basics:

  1. higher leverage results in higher sensitivity
  2. total leverage is a product of operating leverage and financial leverage
  3. operating leverage is % change in operating income divided by % change in units sold
  4. financial leverage is % change in net income divided by % change in operating income
  5. total leverage is therefore % change in net income divided by % change in units sold

After reviewing the above bullets, particularly #2 & 5, and information in the question, it is evident that Grundlegend has a relatively higher financial leverage. Higher financial leverage translates into higher total leverage which results in higher sensitivity. And that’s the reason why Option A is incorrect. Hope it clears!

Why is the Financial leverage higher? As the Debt increases so the Net Income falls so the % change in Net Income will be lower right? Please elaborate.