Financial leverage occurs when the after-tax cost of borrowed funds is:
A)less than the after-tax return on assets.
B)greater than the after-tax return on assets.
C)equal to the after-tax return on assets.
D)greater than the after-tax return on equity.

Question

Quizplus · Accepted Answer

Financial leverage occurs when the company borrows money at a rate lower than the rate of return on assets. This is because the borrowed funds are used to invest in assets that generate higher returns than the cost of the borrowed funds, thus increasing the profits of the firm. Hence, option A is the correct answer. Option B is incorrect because if the cost of borrowed funds is higher than the returns generated from assets, it would result in a reduction in profits. Option C is incorrect because financial leverage requires that the cost of borrowed funds be lower than the return on assets. Option D is incorrect because financial leverage does not relate to the return on equity but to the return on assets.

Financial Leverage Occurs When the After-Tax Cost of Borrowed Funds