Question

How does leverage alter the risk-return trade-off of investors? Try to explain your answer also in numerical terms, with an example.

Answer 1

Leverage is defined as proportion of debt in capital structure of company that is Financial leverage measure proportion of debt in capital structure. A firm that employs a relatively large proportion of debt in its capital structure will have a relatively High degree of financial leverage. Interest payment on debt is considered as expense for company. So, company can deduct interest expense from taxable income. So, company need to pay lesser tax because of debt capital.

A high debt ratio denotes tradeoff between risk and return.

The tradeoff theory assumes that there are benefits to leverage within a capital structure up until the optimal capital structure is reached.

Capital structure decision is based on tradeoff theory. the tradeoff between level of risk and overall cost of capital/ there is two main part of capital structure that is debt and equity. the cost of debt is usually less and interest payment on debt capital is deductible from taxable income. So, if company use more debt than overall cost of capital of company reduced.

at the same time when company use more debt the probability of bankruptcy increase. so, the manager must tradeoff between bankruptcy risk and cost of capital while making decision about capital structure.