Financial leverage is believed to be favorable if:
1. ROI is lower than cost of debt
2. ROI is higher than cost of debt
3. Debt is not easily available
4. If the interest rate is high
Financial leverage is believed to be favorable if:
1. ROI is lower than cost of debt
2. ROI is higher than cost of debt
3. Debt is not easily available
4. If the interest rate is high
Solution
Option 1 -> If ROI is lower than cost of debt, the company earns less than it pays in interest, destroying shareholder value and creating negative leverage.
Option 2 -> When ROI exceeds the cost of debt, the company earns more than it pays in interest, and the positive spread magnifies returns to equity holders, making leverage favorable.
Option 3 -> Debt availability relates to access and financing constraints, not to whether leverage creates value or is financially beneficial.
Option 4 -> High interest rates increase the cost of debt, making it harder to generate returns that exceed borrowing costs, thus making leverage less favorable.
Hence, Option 2: ROI is higher than cost of debt -> Financial leverage is favorable when the return on investment exceeds the cost of borrowing because the positive spread between what the company earns and what it pays in interest amplifies returns to shareholders, creating value through the efficient use of debt -> correct
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