Final answer:
A highly leveraged firm is one that carries a significant amount of debt, leading to a high risk/return trade-off and potential financial difficulties during economic downturns due to obligatory interest payments.
Therefore, the correct answer is: option 3) The firm carries a lot of debt.
Step-by-step explanation:
When a firm is considered to be highly leveraged, it primarily means that the firm carries a lot of debt in its capital structure.
This indicates that the firm has chosen to finance its operations and investments largely through borrowing, which can be via bank loans or the issuance of bonds.
The use of leverage can lead to a higher risk/return trade-off because while debt can amplify profits during good economic times, it also increases the firm's financial risk during downturns as the firm is committed to making interest payments regardless of its income levels.
A highly leveraged firm may face difficulty during economic downturns as it might struggle to meet its debt obligations, leading to potential solvency issues or restrictive measures to preserve cash.