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 always true since leverage makes the firm more disciplined and increases returns.
D. This is true, but the higher returns will be associated with increased risk.

Answer 1

option is D

This is true, but the higher returns will be associated with increased risk.

Increased use of debt can increase the return on equity by increase in net income because interest expense is a tax deductable expense and this interest tax shield would increase the net profit on the one hand and use of debt on the other hand would reduce the amount of total equity invested in a business so as a result value of return on equity would be high if debt is used in the company. This situation will exist till the time upto when after tax cost of debt is less than cost of equity. On the other hand more use of debt in capital structure would increase the financial risk related to capital structure.