Question

Holding all other factors​ constant, a firm that is subject to a greater level of business risk should employ less financial leverage than an otherwise equivalent firm that is subject to a lesser level of business risk. True False

Answer 1

Answer:

The correct answer is True.

Explanation:

Financial leverage is the use of debt to acquire assets that generate more assets. It is a concept used in operations where the investment that is made is greater than the money that is actually available, so that with a lower amount of money a greater possibility of profit or loss can be achieved. Therefore, it implies a higher risk.

The main instrument for leverage is debt, which allows you to invest more money than is available thanks to what has been borrowed. But you can also achieve financial leverage through many other financial instruments, such as derivatives, futures or CFDs.

We can find three types of financial leverage:

• Positive leverage: this type of leverage occurs when the economic profitability (return obtained from assets) that occurs with the leverage operation is higher than the cost of the debt, that is, generally at the interest rate paid at bank for the loan.
• Neutral leverage: occurs when the economic return is equal to the interest rate paid on the loan. Employment or increased indebtedness does not cause variation in economic profitability.
• Negative leverage: it occurs when the economic profitability is lower than the interest rate that is being paid for the debt or for the funds obtained in the loans. In this case, obtaining the debt is unproductive.

Answer 2

Answer:

True

Explanation:

In theory this statement is definitely true, but it is also an example of how theory and reality rarely meet.

A company that is doing great, like Apple, Google or Microsoft, does not need to borrow money since they have tons of it. They could even buy small countries with their money. Not even the COVID will stop them, they have so much cash they can operate without any problems. Who needs to borrow money? Shale oil companies that are about to go bankrupt, clothing retailers and other companies that have been hit by the current crisis. If you are making millions per day you do not need to borrow money. You need to borrow money for two reasons:

1. obviously your company doesn't have enough money to carry out a project or operate normally (low retained earnings)
2. even if you could raise money through issuing new stocks, the cost of equity is too high and it could hurt you further

In conclusion, even though economic theory states that companies that have a high level of business risk should not have high levels of financial leverage, they are the ones that actually borrow money in the real world.