At her company's annual party, Sally overheard one of the executives mention that the company is highly leveraged. Sally, who recently bought 300 shares of the company's stock, is very interested in this bit of information because she knows that leverage:
A) will protect her return on investment if the company experiences a downturn in sales.
B) will increase the amount of taxes she will have to pay on her dividends.
C) means that the firm is financed with a sizeable amount of debt, which can increase the return on her equity investment.
D) is a timeproven way to both improve the expected return on equity and reduce the financial risk to stockholders.

Question

At her company's annual party, Sally overheard one of the executives mention that the company is highly leveraged. Sally, who recently bought 300 shares of the company's stock, is very interested in this bit of information because she knows that leverage:
A) will protect her return on investment if the company experiences a downturn in sales.
B) will increase the amount of taxes she will have to pay on her dividends.
C) means that the firm is financed with a sizeable amount of debt, which can increase the return on her equity investment.
D) is a time­proven way to both improve the expected return on equity and reduce the financial risk to stockholders.

Quizplus · Accepted Answer

Leverage means that the firm is financed with a sizeable amount of debt, which can increase the return on equity investment. However, it also increases the financial risk to stockholders. Option A is incorrect because leverage doesn't protect the return on investment if the company experiences a downturn in sales. Option B is incorrect because leverage doesn't impact the amount of taxes paid on dividends. Option D is incorrect because while leverage can increase the expected return on equity, it also increases the financial risk to stockholders.

At Her Company's Annual Party, Sally Overheard One of the Executives