How does financial leverage affect return on equity (ROE)?

How does financial leverage affect return on equity (ROE)?

• A. Always reduces ROE
• B. Has no effect on ROE
• C. Increases ROE when earnings exceed the cost of debt, but increases risk and volatility of ROE
• D. Increases ROE regardless of earnings level with no risk impact

Answer: (C)

Financial leverage changes ROE by magnifying the profits attributable to shareholders when the company earns enough to cover the cost of debt. ROE is about how much net income you generate for each dollar of equity. When you finance with debt, you have a fixed obligation to pay interest. If the firm’s earnings are high enough that after paying interest there’s still extra profit, that extra profit flows to equity owners and grows much more on a per-equity-dollar basis, boosting ROE. This effect tends to be strongest when the operating returns on assets exceed the after-tax cost of debt. But the flip side is important: debt fixes a cost that must be paid regardless of how well the firm performs. If earnings fall or debt costs rise, those fixed payments erode net income, which can shrink ROE and make it more volatile. In other words, leverage can push ROE up in good times but makes it riskier and more variable in bad times. So the correct view is that financial leverage increases ROE when earnings exceed the cost of debt, but also increases the risk and volatility of ROE.

Financial leverage changes ROE by magnifying the profits attributable to shareholders when the company earns enough to cover the cost of debt. ROE is about how much net income you generate for each dollar of equity. When you finance with debt, you have a fixed obligation to pay interest. If the firm’s earnings are high enough that after paying interest there’s still extra profit, that extra profit flows to equity owners and grows much more on a per-equity-dollar basis, boosting ROE. This effect tends to be strongest when the operating returns on assets exceed the after-tax cost of debt.

But the flip side is important: debt fixes a cost that must be paid regardless of how well the firm performs. If earnings fall or debt costs rise, those fixed payments erode net income, which can shrink ROE and make it more volatile. In other words, leverage can push ROE up in good times but makes it riskier and more variable in bad times.

So the correct view is that financial leverage increases ROE when earnings exceed the cost of debt, but also increases the risk and volatility of ROE.