Which one of the following statements concerning financial leverage is correct?

Question

BlackTom AI · Accepted Answer

The question asks: Which one of the following statements concerning financial leverage is correct?

Option 1: Financial leverage magnifies both profits and losses. This is a true statement. Financial leverage uses debt financing, which amplifies the return on equity when earnings are steady, but also magnifies losses when earnings decline, since interest obligations remain fixed. The mechanism is that debt increases the fixed costs in the form of interest, so percentages of ROE can swing more dramatically.

Option 2: Increasing financial leverage will always decrease the earnings per share. This is incorrect. While higher leverage increases risk and can reduce EPS if profits fall, it can also raise EPS when the firm has strong, stable earnings and the cost of debt is lower than the return on assets, leading to a leverage-driven uplift in per-share profitability.

Option 3: Financial leverage has no effect on a firm's return on equity. This is false. ROE is directly affected by leverage because debt changes the equity base and the net income available to shareholders after interest, thus altering ROE, sometimes significantly.

Option 4: Financial leverage increases profits and decreases losses. This is misleading. Leverage can magnify profits, but it also magnifies losses; it does not inherently decrease losses. If the firm experiences adverse outcomes, leverage can cause losses to be larger, not smaller.

Option 5: Financial leverage refers to the use of common stock. This is incorrect. Financial leverage refers to the use of debt financing (borrowed funds), not to the use of common stock. Equity financing does not create the fixed interest obligation characteristic of leverage.

Which one of the following statements concerning financial leverage is correct?

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