In what way does financial leverage impact investment decisions?

Financial leverage refers to the use of borrowed funds (debt) to finance the acquisition of assets with the expectation that the income generated will exceed the cost of borrowing. This mechanism influences investment decisions in several vital ways.

When a company employs financial leverage, it indeed increases the risk associated with investments because the debt obligation must be met regardless of the performance of the business. If the investment yields a return greater than the cost of the debt, the potential return on equity can be significantly amplified, making financial leverage an attractive strategy for investors seeking higher profits. Conversely, if the investment does not perform well, the risks increase as the company still needs to service the debt, possibly leading to financial distress.

Investors must weigh these risks and potential returns when making decisions. The allure of higher returns often makes leverage a key factor in strategic planning and capital structure decisions within a company.