David is trying to decide whether to add capital through investing more of his own money or through borrowing money from the bank.To help him decide, you remind him that as long as his business's rate of return on its assets is greater than the cost of the debt, his rate of return on equity will _____ as the business uses more debt.
A)decrease
B)increase
C)remain the same
D)fluctuate

Question

Quizplus · Accepted Answer

This is known as financial leverage. By using debt financing, a company can increase its return on equity because the cost of debt is lower than the cost of equity. As a result, the profits generated from the assets funded by the debt can boost the return on equity. However, if the return on assets falls below the cost of the debt, the increased financial leverage can also decrease the return on equity. Therefore, David needs to carefully evaluate the risk and stability of his business before deciding to use debt financing.

David Is Trying to Decide Whether to Add Capital Through