- CFA Exams
- CFA Exam: Level I 2021
- Study Session 11. Corporate Finance (2)
- Reading 34. Measures of Leverage
- Subject 2. Financial Risk and Financial Leverage

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**CFA Practice Question**

When a firm increases debt in its capital structure, ______

II. expected return on the firm's common stocks increases.

III. the IRRs of new projects increase.

I. expected return on the firm's assets increases.

II. expected return on the firm's common stocks increases.

III. the IRRs of new projects increase.

Correct Answer: II only

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**User Contributed Comments**
12

User |
Comment |
---|---|

setmefree |
under CAPM, higher beta, higher expected return on equity. since leverage causes equity to be riskier, hence beta is increased, result in higher expected return on equity. |

haarlemmer |
By the way, what is the term 'IRA' referring to? |

yanpz |
When debt increase, the risk for debt lender increases, so cost of debt will increase. Since both cost of debt and cost of equity increase, the expected return on assets should increase too, right? |

xyz007 |
why the answer is II? |

mtcfa |
ROA is net income/average assets. Netincome may remain unchanged, resulting in a stable ROA. However, because there is now less equity in the capital structure, the return on that equity has increased. |

PASS0808 |
IRR of the new project remain same. |

GJCFA |
Shareholders are the last in the line when a company goes insolvent. If company is adding more debt, surely they will require more return! |

johntan1979 |
ROA in I should decrease, because increase in debt because of what? To finance increase in assets. Since assets is the denominator, ROA decreases with the increase in debt. |

gill15 |
No johnaton....ROA does not decrease....it doesnt increase either...We dont know what happens with more info on it...you dont need to know the specifics but just know that you dont know for CFA I. |

Shaan23 |
Just think back to last unit guys Blevered = Bu ( 1 + (1 - t) D/E) increase D then beta increases --- therefor r equity increases. |

schweitzdm |
Good point, Shaan23 |

fabsan |
Assets = Liabilities + Owner Equity If the firm increases the Debt, Not only the right side of the Equation increases but the left for the same amount. The unknown here is the Income Statement. We do not know by how much the Net Income will increase, therefore we cannot say with certitude if ROA will increase or decrease or remain stable. We can say with a higher probability that the expected return increase. The firm by increasing the Assets (after raising debt) will be able to produce more and generate a higher net income. Since the level of equity (common stock) is given stable therefore expected return measure by ROE will be higher. |