Question

When will highly leveraged firms have high expected returns

Answer 1

Highly leveraged firms generally add more debt capital to enhance equity returns.

The high leverage will fetch high returns because the firm adds debt capital which has lower cost than the cost of equity capital and finally firms can take up more project with same equity levels and this enhances the return for equity holders. If firm is earning 10% on its capital of $100 without debt then this 10% goes directly to equity as $10 but when we add debt capital of $100 for interest cost of 5% then firm can earn same 10% but on $200 and now, the total earnings will be $20. From $20 cost of Interest is 5$ and balance $15 goes to Equity and Equity with $100 will now earn $15 i.e. 15% and this is the effect of leverage.

High return comes with additional risk of debt borrowing and its rollover costs hence there is trade off between risk and return.