How does leverage affect a company's risk and return?

How does leverage affect a company's risk and return?

• A. Leverage reduces risk but increases potential profits.
• B. Leverage has no effect on risk.
• C. Leverage only affects equity holders but not lenders.
• D. Leverage amplifies returns but increases financial risk and potential losses when earnings are insufficient to cover fixed costs.

Answer: (D)

Leverage means using debt or other fixed-cost financing to fund assets. Because those fixed obligations must be paid regardless of how well the business performs, leverage amplifies what happens to returns when earnings change. When earnings are strong and cover the fixed costs, the leftover profit flowing to owners is larger than it would be without debt, so returns rise more than they would in a purely equity-financed scenario. But if earnings are not sufficient to cover those fixed costs, the company still has to pay interest and debt obligations, which can erode profits and even lead to losses or financial distress. In this sense, leverage increases financial risk while also potentially boosting returns when times are good. Other statements miss this balance: leverage does affect risk, it doesn’t only affect equity holders or exclude lenders, and it does not reduce risk.

Leverage means using debt or other fixed-cost financing to fund assets. Because those fixed obligations must be paid regardless of how well the business performs, leverage amplifies what happens to returns when earnings change.

When earnings are strong and cover the fixed costs, the leftover profit flowing to owners is larger than it would be without debt, so returns rise more than they would in a purely equity-financed scenario. But if earnings are not sufficient to cover those fixed costs, the company still has to pay interest and debt obligations, which can erode profits and even lead to losses or financial distress. In this sense, leverage increases financial risk while also potentially boosting returns when times are good.

Other statements miss this balance: leverage does affect risk, it doesn’t only affect equity holders or exclude lenders, and it does not reduce risk.