Question

11. A bank has equity of $100. It borrows at 3% and lends at 5%.

A. Explain how leveraging affects the profitability and insolvency risk (you may want to compare leveraging ratios of 10 and 20 in your answer).

B. Explain how and why leveraging ratios evolved after the 1980s in the U.S. How is their evolution relevant to the 2008 financial crisis.

Answer 1

(a) A company's return on equity increase because the use of leverage increases stock and increasing at risk which result in increses in returns. if a company is financially over leveraged a decrease in return on equity occur.

in other words we can also say that, the main risk of leverage becomes apparent as a company takes on too much debt the amount of leverage a company incurs should be directly related to its liquidity and solvency.if company takes too much debt, it will be unable to meet its payment requirement with its short trem and long term cash flows.

(b) unregulated us corporations dramatically increased their debt usage over the past century. Aggregate leveage - low and stable before 1945 more than tripled between 1945 and 1970 from 11% to 35%, eventually reaching 4% by the early 1990s. the median firm in 1946 had no debt but by 1970 had a leverage ratio of 31%. this increase occured in all unregulated industries and affected firms of all sizes.. changing firm characteristics are unable to account for tgis increase . rather , changes in government borrowing macroeconomic uncertainty, and financial sector development play a more prominent role , despite this increase among unregulated firms, a combination of stable debt usage among regulated firms and a decrease in the fraction of aggregate assets held by regulated firms over this period resulted in a relatively stable economy wide leveage ratio during the 20th century.