Question

How does the interest rate on new debt influence the use of financial leverage?

Short answer

The interest rate on the debt financing and the financial leverage are directly related to each other. When the company raise funds through debt, the interest cost of the company increases, the financial leverage also increases. Hence, the interest rate on new debt may increase the financial leverage of the company. The excessive amount of financial leverage may increase the risk of failure for the company.

Step-by-step solution

Step-by-Step Solution:Step 1: Interest rate on the debt

The interest rate on the debt is the cost of debts for the borrower and the rate of return for the lenders. It is an expense for the borrowing companies.

use of financial leverage

Companies use the financial leverage to finance their assets. It is employed to increase the return on assets. It is increased when the company increases the amount debt in the company. It is so because the interest cost of the company increases which is risky for the company. High financial leverage may affect the company adversely because it may be difficult for the company to repay the debts.