What is meant by the terms "favorable" and "unfavorable" leverage?
What will be an ideal response?
Answer: If a firm can earn a higher rate of return on its investments than it pays in interest on borrowed funds, the difference goes to the firm's owners, its shareholders. The additional money earned will cause Return on Equity to be higher than Return on Assets. In essence, the firm is using "other people's money" to make money for its owners. Leverage can also work in reverse. Interest is a fixed cost. It must be paid whether or not the firm has sufficient earnings. When the rate of return on investments is lower that the interest rate on borrowed, leverage is said to be "unfavorable" and return on owner's equity will be reduced by the difference.
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