Which of the following is true concerning the rate of return earned on shares of a levered ﬁrm in terms of the possible range of earnings? There are no taxes.
A) The returns do not differ from those of an unlevered ﬁrm.
B) The returns are greater than for an unlevered ﬁrm on the upside and equal on the downside.
C) The returns are the same as for an unlevered ﬁrm on the upside and lower on the downside.
D) The returns are greater than for an unlevered ﬁrm on the upside and lower on the downside.
E) The returns are the same as for an unlevered ﬁrm on the upside and greater on the downside.

Question

Quizplus · Accepted Answer

The rate of return earned on shares of a levered firm is greater than for an unlevered firm on the upside (when earnings are high) and lower on the downside (when earnings are low). This is because leverage magnifies both gains and losses. Without taxes, the benefits of leverage are not offset by the costs of interest payments. Therefore, the returns are greater on the upside but lower on the downside compared to an unlevered firm. Option D accurately describes this situation.

Which of the Following Is True Concerning the Rate of Return