Final answer:
A firm with a high degree of combined leverage will indeed experience higher earnings during the expansionary phase of the business cycle, due to the influence of both operating and financial leverage. The firm's fixed costs and debt obligations amplify earnings increases when revenues rise; however, the same leverage also increases the firm's risk during downturns.
Step-by-step explanation:
The statement that a firm with a high degree of combined leverage will experience higher earnings during the expansionary part of the business cycle is true. Combined leverage refers to the effect of both operating leverage and financial leverage on a firm's earnings. In periods of economic expansion, increased sales typically lead to higher operating income due to fixed costs being spread over more units (operating leverage). If a firm also has a high degree of financial leverage, meaning they have significant debt, the earnings before interest and taxes (EBIT) will result in greater increases in earnings per share (EPS) as the interest on debt remains constant while revenues rise. Therefore, earnings magnify during economic upswings when leverage is high. However, the converse is also true, making such firms more vulnerable during economic downturns.
It is important to understand that leveraging amplifies outcomes, both positive and negative. During expansion, when businesses typically see increased revenue, firms with higher leverage will see a more pronounced effect on their bottom line due to their fixed cost structure and debt obligations. But this also means that in times of contraction, the effect on earnings can be more severe. This principle is known as the leverage cycle, where borrowing and lending behaviors intensify economic fluctuations.
Therefore, while a high degree of combined leverage can result in high earnings growth during favorable economic conditions, it also increases the firm's financial risk and potential for loss during adverse conditions. It is a tool for growth that comes with its risks.