The correct option is a) deleveraging.
When the value of loans begins to drop, the net worth of financial institutions falls causing them to cut back on lending in a process called deleveraging.
<h2>
What is Deleveraging?</h2>
Deleveraging is the process by which a business or person tries to reduce their overall financial leverage. Deleveraging, then, is the elimination of debt and the polar opposite of leverage. Paying up any outstanding debts and commitments on an entity's balance sheet right away is the quickest way to deleverage.
The following strategies can be used by a business to reduce its debt:
- By offering assets, bonds, and a portion of the firm for less, a company can reduce its debt.
- It can refinance existing debt to lower interest rates and monthly payments.
- By spending extra cash from business operations, it can reduce its debt.
- A publicly traded firm can reduce its debt by issuing more stock.
<h3><u>Formula</u></h3>
Deleveraging's effects can be assessed using financial ratios including return on assets, debt-to-equity, and return on equity.
Return on Assets (ROA) = Net Income / Average Assets
Debt-to-Equity Ratio = Total Debt / Total Equity
Return on Equity (ROE) = Net Income / Total Equity
Example:
Company A uses $3 million in equity and $7 million in debt to purchase a $10 million asset. The net income for the year is $600,000.
ROA is 600,000/10,000,000, or 6%.
Debt-to-equity ratio: 2.3x (7,000,000/3,000,000).
ROE is equal to 600,000/3,000,000, or 20%.
Assume that at the end of the year, Company A decided to pay $5,000,000 of liabilities using $5,000,000 of assets. The corporation now has $5,000,000 in assets and $2,000,000 in debt
ROA:
600,000,000/5,000,000=12%
Debt-to-equity ratio: 0.6x (2,000,000/3,000,000).
ROE is equal to 600,000/3,000,000, or 20%.
Investors and lenders will favor scenario 2 over scenario 1 since scenario 2 involves less leverage and the company reports more attractive ratios.
Learn more about Deleveraging and troubled Asset here:
brainly.com/question/24448358
#SPJ4
