Briefly explain the leverage effect and how it is related to the expected risk for shareholders.

Finance assignment – corporate finance

The leverage effect is the impact that debt can have on a company’s expected return. The leverage effect occurs because interest payments are required to pay off any outstanding debt, while equity investments don’t require these obligations. Companies with greater levels of debt are more likely to earn higher returns due to increased income from loan repayments.

This also means shareholders are at greater risk when they invest in companies that have higher levels of leverage. These firms could lose their profits and become unable to pay their debts. This can lead to a dramatic decrease in shareholder value.

Overall, the leverage effect describes how debt can influence both a firm’s expected return as well as its associated risk for shareholders. This information helps investors to make informed decisions about which companies they should invest or not so they maximize their returns and manage risk.

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