MANAGEMENT

Detailed explanation-1: -As debt increases, shareholders require higher returns since they face higher financial risk. This higher financial risk results from spreading the firm’s business risk over a proportionately smaller equity base.

Detailed explanation-2: -Debt and equity differ significantly in their cost and riskiness for the firm Cost of debt is lower than cost of equity for a firm because lender’s risk is lower than equity shareholder’s risk, since lenders earn on assured return and repayment of capital and therefore they should require a lower rate of return.

Detailed explanation-3: -So the use of leverage raises the level of risk that increases returns as it increases the stock’s leverage. The use of debt capital and gearing as a company or an individual will always result in an increased risk level, as income must be used to pay down debt even when earnings or cash flows are reduced.

Detailed explanation-4: -Answer» D. Financial leverage. View all MCQs in: Strategic Financial Management.