A CEO explains “we can increase our expected return on equity by increasing leverage.” Which of the following is the best response to this statement?A.This statement is not necessarily true—it depends upon a whole range of factors.B.This is false, equity holders are residual claimants and increased interest payments will leave less profit to distribute to shareholders.C.This is true, but the higher returns will be associated with increased risk.D.This is always true since leverage makes the firm more disciplined and increases returns.
Question
A CEO explains “we can increase our expected return on equity by increasing leverage.” Which of the following is the best response to this statement?A.This statement is not necessarily true—it depends upon a whole range of factors.B.This is false, equity holders are residual claimants and increased interest payments will leave less profit to distribute to shareholders.C.This is true, but the higher returns will be associated with increased risk.D.This is always true since leverage makes the firm more disciplined and increases returns.
Solution
The best response to this statement is C. "This is true, but the higher returns will be associated with increased risk."
While it is true that increasing leverage (i.e., taking on more debt) can increase the expected return on equity, it also increases the risk to equity holders. This is because the more debt a firm has, the more interest it must pay. This leaves less money for equity holders (the owners of the firm), and increases the risk that the firm will not be able to meet its financial obligations. If the firm goes bankrupt, equity holders are last in line to be paid, after debt holders. Therefore, while leverage can increase returns, it also increases risk.
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