True or False. An increase in financial leverage generally results in a higher return on equity (ROE).

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Business

Henry Barker

15 February, 09:23

True or False. An increase in financial leverage generally results in a higher return on equity (ROE).

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Crystal Ramirez · Answer 1

False

Explanation:

An increase in financial leverage only results in a higher return on equity when the return on assets is higher than the cost of the leverage (i. e. the interest rate on debt).

Given the relationship below among, total assets, equity and debt (leverage)

total assets = equity + debt

and equity = total asset - debt,

We can deduce the equation below

Return on Equity = Return on Asset (ROA) - Return to Debt (ROD) (approximately)

Accordingly, if ROA is greater than ROD, an increase in financial leverage will result in a higher ROE. If the cost of debt (ROD) is however higher than ROA, an increase in financial leverage will result in a lower ROE.