Understanding Financial Leverage

Easy Measures Of Leverage Financial Leverage

ABC Corporation is considering a new investment project that will be financed through a combination of debt and equity. The management is exploring the effects of financial leverage on the company's earnings. Financial leverage refers to the use of debt to acquire additional assets. Increased financial leverage can magnify the potential returns on equity; however, it also increases the risk of loss in times of poor performance.

Which of the following statements accurately describes a key aspect of financial leverage?

Financial leverage increases the potential return on investment only when the cost of debt is less than the return on equity.

Financial leverage always increases the overall risk of the firm regardless of the cost of borrowing.

Financial leverage has no effect on the company's earnings before interest and tax (EBIT) but magnifies net income.

Hint

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