The correct answer is: A. Reduces DFL.
DFL stands for “degree of financial leverage”. It is a measure of how sensitive a company’s earnings per share (EPS) is to changes in its EBIT. A higher DFL indicates that a company’s EPS is more sensitive to changes in its EBIT, and vice versa.
Preference shares are a type of equity that ranks above common shares in terms of dividend payments. This means that if a company is unable to pay its dividends, preference shareholders must be paid before common shareholders.
Debt finance is a type of financing that involves borrowing money from a lender. The lender will charge interest on the loan, which must be paid back over time.
The use of preference share capital as against debt finance reduces a company’s DFL. This is because preference shareholders have a higher claim on a company’s assets than debt holders. If a company is unable to pay its debts, the debt holders will be the first to lose money. However, if a company is unable to pay its preference dividends, the preference shareholders will only lose their investment.
As a result, the use of preference share capital reduces a company’s risk of financial distress. This is because preference shareholders are less likely to force a company into bankruptcy than debt holders.
Here is a brief explanation of each option:
- A. Reduces DFL. As explained above, the use of preference share capital reduces a company’s DFL.
- B. Increases DFL. This is incorrect. The use of preference share capital reduces a company’s DFL, not increases it.
- C. Increases financial risk. This is incorrect. The use of preference share capital reduces a company’s financial risk, not increases it.
- D. Both a and b. This is the correct answer. The use of preference share capital reduces a company’s DFL and increases its financial risk.