Reference no: EM132555218

Companies also assume risk when deciding on how to finance their operations. As the DuPont equation clearly indicates, a company's ROE (arguably, one of - if not the - most important internal ratios a shareholder should care about) depends on its equity multiplier, which is a reflection of the amount of debt it has relative to equity. Also, a fixed expense is independent of the level of sales or operating activity. This certainly applies to interest costs. Whenever a company borrows funds, it is creating a fixed expense (interest) it will need to pay, regardless of how well or poorly the company performs. The more debt it has, the greater the fixed cost. Conversely, when using equity, the company has a choice whether to pay dividends to the shareholders, or suspend it in a bad year.

Question 1: So, at one level, the question of how much financial leverage to take on, seems like just another fixed vs. variable cost structure decision. But is it really?

Question 2: What other factors should be considered? Is it necessarily the case that a company that is comfortable with high operating leverage should be equally at ease with high financial leverage? Will the company's lenders make a distinction?

Question 3: As a shareholder, should you be indifferent between the two types of risk?