Financial leverage is the use of borrowed funds to increase the potential return on investment. It involves amplifying both potential gains and potential losses by using debt financing.
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1. Financial leverage can magnify both profits and losses, impacting a firm's risk profile.
2. The degree of financial leverage (DFL) is a metric used to assess how sensitive a company's earnings per share (EPS) are to changes in its operating income.
3. High financial leverage can lead to higher interest expenses, which must be paid regardless of business performance.
4. Firms with stable cash flows are more likely to benefit from financial leverage compared to firms with volatile cash flows.
5. The optimal capital structure balances financial leverage and equity to minimize the cost of capital while maximizing firm value.
Review Questions
1. How does financial leverage affect a company's risk and potential returns?
2. What is the Degree of Financial Leverage (DFL), and why is it important?
3. Why might a company with stable cash flows choose to use high financial leverage?