Financial leverage is the use of fixed payment

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Unformatted text preview: same as the market risk of its assets. This is to say the beta of its equity, βequity, is the same as its asset's beta, βasset. Financial leverage is the use of fixed payment obligations, such as notes or bonds, to finance a company's assets. The greater the use of debt obligations, the more financial leverage and the more risk associated with cash flows to owners. So, the effect of using debt is to increase the risk of the company's equity. If the company has debt obligations, the market risk of its common stock is greater than its assets' risk (that is, βequity greater than βasset), due to financial leverage. Let's see why. Consider an asset's beta, βasset. This beta depends on the asset's risk, not on how the company chose to finance it. The company can choose to finance it with equity only, in which case βequity greater than βasset. But what if, instead, the company chooses to finance it partly with debt and partly with equity? When it does this, the creditors and the owners share the risk of the asset, so the asset's risk is split between them, but not equally because of the nature of the claims. Creditors have seniority and receive a fixed amount (inte...
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This note was uploaded on 02/07/2014 for the course MIS 304 taught by Professor Mejias during the Spring '07 term at Arizona.

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