What effect does financial leverage have on potential returns?

Financial leverage involves using borrowed funds to invest in business operations or other assets, aiming to amplify potential returns on equity. When a company utilizes financial leverage, it increases the capital available for investment beyond its own equity base.

The primary reason that financial leverage magnifies potential returns is due to the fixed nature of interest expenses relative to the variable returns generated by investments. If the returns on investment exceed the cost of the borrowed funds, the excess returns increase the overall profitability for the equity holders, thereby enhancing returns on their investment. For instance, if a company borrows money at a lower interest rate and invests those funds resulting in higher returns, the profits will be greater than they would have been without leverage, ultimately leading to a higher return on equity.

However, it's essential to recognize that while leverage can enhance returns, it simultaneously increases risk. If the returns on the investments do not exceed the interest payments on the debt, the losses can be magnified, leading to a reduction in overall equity. This dual nature illustrates the importance of careful financial management when employing leverage, as the potential for high returns comes with the risk of significant losses. Thus, option A accurately captures the essence of financial leverage, identifying its ability to magnify potential returns while also increasing risk