Final answer:
The operating risk of the firm increases as the level of the firm's debt increases. Higher debt leads to higher interest payments, reducing cash available for other activities. This can also lead to credit downgrades and increased borrowing costs.
Step-by-step explanation:
The operating risk of the firm increases as the level of the firm's debt increases. When a firm takes on more debt, it becomes more vulnerable to financial distress and default. This increased risk is due to the higher interest payments and the potential difficulty in meeting them as debt levels rise.
For example, if a company borrows a large amount of money to finance its operations, it may have to allocate a significant portion of its earnings to interest payments. This reduces the amount of cash available for other business activities, such as research and development or expansion.
Furthermore, high levels of debt can also lead to credit downgrades, which can increase borrowing costs and further exacerbate the operating risk of the firm.