Lesson 2 of 7 · 14 min
Leverage: higher return, higher risk
Borrowing at a rate below the return on assets lifts return on equity, but it also makes shareholder returns swing much more, so debt is cheap for the issuer yet risky.
In short
- Financial leverage is the use of more debt for a given amount of equity.
- If the interest rate is below the return on assets, leverage raises ROE; it also widens the range of ROE outcomes.
- Issuer view: debt is cheaper but riskier (promised payments, contract restrictions, possible bankruptcy). Equity carries no such risk for the issuer.
- Investor view: equity is riskier than debt (residual claim), with unlimited upside but a possible total loss.
- Shareholders often prefer debt to new shares because new shares cause dilution.
- Funding a project with cash on hand avoids both dilution and interest cost.
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