Financial leverage in my opinion is like robbing Peter to pay Paul. The business is taking money from one source and allocating it to another to hopefully make a bigger profit. The degree to which an investor or business is utilizing borrowed money. Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. Financial leverage is not always bad, however; it can increase the shareholders' return on their investment and often there are tax advantages associated with borrowing. .
With a long-term debt that has a cost a firm 10% but the firm can turn around and invest this amount for 12%, the return would be 2%. Therefore, the borrowed funds have been invested to earn a greater rate of return than the interest rate being paid on the borrowed funds. The owners of the firm have a greater return on their investment and have a positive financial leverage. "The excess return on borrowed funds is the reward to owners for taking the risk of borrowing money at a fixed cost." (p. 162).
If the firm earned a lower return on the investment, lower than 10%, the financial leverage would be negative and the Return of Equity would be lower than the Return of Investment. .
In conclusion, financial leverage is a risk. As stated before, you are robbing Peter to pay Paul. If the firm cannot pay Peter and Paul back then the firm can be forced into bankruptcy or jeopardize the chances of acquiring loans in the future. .
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