Which of the following statements about the ‘Financial Leverage’ and ‘Borrowing to Invest’ sections of the lecture material are TRUE: As long as the expected return on assets is greater than the cost of debt (interest rates), adding financial leverage to an investment magnifies both expected return on equity and also total risk of that equity. An investor has a margin loan on an Exchange Traded Fund that tracks the ASX200 index. The value of the investment (asset) is $100,000 and they have a $50,000 margin loan. If the ASX200 were to suddenly fall in value by 30%, that investor would likely experience a margin call.

Question

BlackTom AI · Accepted Answer

Question restatement: You are asked about two statements regarding Financial Leverage and Borrowing to Invest. The answer options present four possible judgments about those statements.

Option A: Neither of the statements are true (both are false). Here, we would be claiming that neither the leverage effect on ROE/ risk, nor the margin-call scenario, holds under the given conditions. In standard leverage theory, if the return on assets exceeds the cost of debt, financial leverage tends to amplify both the expected return on equity and the risk of that equity. So this option would be inconsistent with fundamental finance principles.

Option B: Only statement 1 is true. This would mean the leverage effect on ROE/risk holds, but the margin-call scenario does not occur under the 30% drop. However, with a 30% depreciation of the asset, equity falls substantially while the loan balance remains, which typically pushes the loan-to-value ratio higher and makes a maintenance-margin breach likely. Thus this option undervalues the margin-call risk.

Option C: Only statement 2 is true. This would claim the margin-call scenario is true but the leverage effect on ROE/risk is not. Since leverage generally magnifies both return and risk when ROA > cost of debt, failing to acknowledge the ROE/risk amplification would be incorrect given the stated condition.

Option D: Both statements are true (neither are false). For the first statement, when the expected return on assets exceeds the cost of debt, adding financial leverage increases the potential upside in equity returns (ROE) and also raises the potential downside risk, i.e., total risk of that equity. The second statement describes a margin loan of 50k secured against a 100k asset. If the asset value falls by 30%, the asset value becomes 70k, leaving equity = 70k − 50k = 20k. This tightened equity position increases the risk of a margin call, since loan-to-value is now 50k/70k ≈ 71%, which commonly triggers margin maintenance requirements. Therefore, the described margin-call risk is plausible, making the statement true as well.

Summary assessment: The first statement aligns with the classic leverage effect where positive, asset-based returns paired with debt cost advantage lead to higher ROE and higher risk. The second statement describes a scenario in which a sizable decline in asset value triggers a margin-call risk given the existing leverage. Taken together, both statements are true, and the option asserting that both are true matches this analysis.

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