We use the term leverage to describe the use of debt in the firm' capital structure because:

Question

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Leverage refers to the use of debt in a company's capital structure. By using debt, a company is able to magnify the potential expected return to equity. This means that if the company is successful, the return to equity holders will be greater than if the company had not used debt financing. However, using debt also magnifies the variability of the expected return, which means that if the company is not successful, the return to equity holders will be lower than if the company had not used debt financing. Therefore, the use of leverage increases both the potential return and the risk for equity holders.

We Use the Term Leverage to Describe the Use of Debt