An increase in the financial leverage of a firm as a result of an increase in outstanding debt has which effect on the potential reward to stockholders while increasing the risk of financial distress or bankruptcy?

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Business

14 January, 02:27

An increase in the financial leverage of a firm as a result of an increase in outstanding debt has which effect on the potential reward to stockholders while increasing the risk of financial distress or bankruptcy?

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Agustin Lutz · Answer 1

When the financial leverage of a firm increases, the potential returns (rewards/profits) of the stockholders increases, but so does the financial risks of the company.

When a company gets a lot of debt, it needs to pay interests and if it isn't able to do so, it can go bankrupt. On the other hand, the company has to distribute dividends only if it made a profit.

An increase in the leverage of a firm results in greater returns, but the higher the return, the higher the risk.