Question

As financial leverage increases, what happens to the following three things?

1) They decrease
2) They stay the same
3) They increase
4) Cannot be determined

Answer 1

When financial leverage increases, it leads to increased financial risk, the return on equity depends on the profitability of investments, and it can increase financial stability or volatility.

Step-by-step explanation:

When financial leverage increases, there are specific effects on different aspects:

1. The financial risk increases: As more debt is taken on, the risk of not being able to meet the financial obligations increases. This, in turn, increases the risk for lenders and investors.
2. The return on equity (ROE) increases or decreases depending on the profitability of the investments made with the borrowed funds. If the borrowed funds are used to generate higher returns than the cost of borrowing, the ROE increases. However, if the investments generate lower returns, the ROE decreases.
3. The level of financial stability or volatility can increase: Higher leverage means a higher proportion of debt in the capital structure. This can make a company more vulnerable to economic downturns and fluctuations in interest rates.