The main disadvantage of financial leverage is that it:
A) increases the firm's taxes.
B) requires owners to invest even more of their own money.
C) reduces the financial return to stockholders when times are bad.
D) requires the firm to make higher dividend payments.

Question

Quizplus · Accepted Answer

Financial leverage refers to the use of borrowed funds to finance the firm's operations, which can increase the return to equity holders when times are good. However, when times are bad, the firm may not generate enough profits to cover the interest and principal payments on the debt, and this can reduce the financial return to stockholders. This is because the interest payments on debt are fixed, whereas the return to equity holders varies with the level of profits. Therefore, the main disadvantage of financial leverage is that it magnifies the financial risk faced by equity holders.

The Main Disadvantage of Financial Leverage Is That It