Increasing the financial leverage of a company will _______ shareholders’ expected returns and ______ their risk.

Question

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Question restatement: Increasing the financial leverage of a company will _______ shareholders’ expected returns and ______ their risk.

Option provided: c. increase; increase

Analysis of options:
- Option c (increase; increase): This statement aligns with financial theory on leverage. Financial leverage magnifies the effect of a company's earnings on shareholders. When a firm borrows more (increases leverage), the fixed interest obligation remains, so any increase in operating income above debt service translates into higher residual returns for shareholders, raising expected returns. At the same time, leverage also increases the variability of those returns because debt amplifies both upside and downside movements; the same percentage change in operating income leads to a larger change in earnings per share and equity value, hence higher risk. In other words, leverage creates a magnifying glass effect on both return and risk, which makes this option consistent with standard explanations of financial leverage.

Why the other options would be incorrect in a typical context: There are no additional options to evaluate in this question, but generally, statements asserting that leverage increases returns while not affecting risk, or decreases risk, or has no effect on risk, would be incorrect. The key concept is that leverage introduces fixed costs (debt service) and changes the risk profile of equity, increasing both the potential upside and downside.

Summary reasoning: The correct interpretation is that higher financial leverage raises both the expected return to shareholders and the risk borne by shareholders, which is exactly captured by option c.

FINS2618-Capital Markets & Institution - T2 2025

Increasing the financial leverage of a company will _ shareholders’ expected returns and their risk.

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