Risk vs. Return

Anonymous
timer Asked: Jul 28th, 2014
account_balance_wallet $5

Question Description

How does leverage impact risk and return? How is risk related to operating and financial leverage? Explain your answer in detail.

Tutor Answer

Crystal P
School: Boston College

Financial leverage is the extent of how much a companies total amount of capital is comprised of debt. Companies will often finance with debt when they are unable to raise enough capital by issuing shares in the market to meet their current business needs. Leverage is used by financial investor's and companies to generate a greater return on their assets. It can have either a negative or positive effect on a company's return on equity as a result of the amount of financial risk that is incurred. When a company reaches it's ideal level of financial leverage then it's amount of equity increases because the leverage increases the stock's volatility which increases the level of risk and as a result increases returns. Therefore, the company has value added from the financial leverage so it has a positive effect on the company. However, if a company decides to incur a huge debt by borrowing at an extremely low rate of interest and then they use their excess amount of funds to invest in high risk investments then the company has over-leveraged itself, and a decrease in their return on equity will mostly likely occur. The risk of the investment will outweigh the expected return and cause stockholders to believe that the investment is too risky and the value of the company's equity will decrease which will then have a negative effect on the company. 

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