Question

Disadvantages of Financial Leverage. The intuition behind the benefits of financial leverage is that a firm can borrow funds that bear a certain interest rate but invest those funds in assets that generate returns in excess of that rate. Why would firms with high ROAs not keep leveraging up their firm by borrowing and investing the funds in profitable assets?

Answer 1

This is because there are some other costs associated with borrowing. There are bankruptcy costs which increase with increased leverage and the profitability also becomes riskier when the leverage is high. In good times, you will have high profits but in bad times you will have huge losses. Hence the risk increases. Also, when we keep on increasing the debt, the new debt is available at increased interest rates. This is another reason why we cannot go on increasing debt