Question

Since borrowing money can increase ROE if the company can use the money borrowed to earn a greater operating return than the cost of the additional debt, why doesn’t a company use 100% financial leverage (entirely nonowner financed and no shareholders' equity)?​

When might a increase short-term gain but at the cost of long-term performance?

Answer 1

Ans:-

Increasing leverage increases ROE as long as the assets earn a greater operating return that the cost of the additional debt.

Financial leverage is also related to risk, the risk of potential bankruptcy and the risk of increased variability of profits.

Companies must, therefore, balance the positive effects of financial leverage against their potential negative consequences.

It is for this reason that we do not witness companies entirely financed with debt.

Note: ROE ( Return on Equity) is the amount of net income returned as a percentage of shareholders' equity.