Question

Firm A has a debt-equity ratio of .5. Firm B has a debt-equity ratio of .8. All other features of these firms are identical. The return on equity of Firm A is:

A. Equally as volatile as the return of equity of Firm B.
B. Less volatile than the return on equity of Firm B.
C. More volatile than the return on equity of Firm B.
D. Unaffected by the debt-equity ratio.

Answer 1

B. Less volatile than the return on equity of Firm B.

Step-by-step explanation:

The leverage ratio indicates the proportion of the shareholders´ and the debt used to finance the company´s assets. A higher ratio means that is more financing coming from debt than the owners and therefore more volatile is the return on equity because there is less equity to get the same revenues.