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 firm's rate of return on assets is greater than the cost of the debt, his rate of return on equity will _____ as the firm uses more debt.
A) decrease
B) increase
C) remain the same
D) fluctuate

Question

Quizplus · Accepted Answer

This is known as the "leverage effect" or "financial leverage." By using debt, David's firm can increase its return on equity since he is able to amplify the returns on his invested capital. However, this strategy also increases the risk that his firm will not be able to generate enough revenue to make its debt payments, causing David to experience larger losses than if he hadn't used debt.

David Is Trying to Decide Whether to Add Capital Through