What occurs to the Return on Equity (ROE) when a company increases its leverage?

When a company increases its leverage, it means that the company is using more debt relative to equity to finance its operations. Increasing leverage can potentially lead to a higher Return on Equity (ROE) because the increased use of debt can amplify the returns generated on the equity held by shareholders.

ROE is calculated as net income divided by shareholder's equity. When a company takes on more debt, it can invest in growth opportunities or increase its operations without needing to raise additional equity. If these investments generate profits greater than the cost of debt (interest expenses), the net income will increase while equity remains relatively stable. As a result, the numerator (net income) increases at a faster rate than the denominator (equity), leading to an increase in ROE.

However, it is important to note that while increased leverage can enhance ROE, it also introduces greater financial risk. If the company does not perform well or cannot cover the interest payments, this could negatively impact ROE, but that scenario does not negate the potential for increased returns when performance is strong.

In contrast, other options suggest a static or negative impact on ROE, which does not align with the financial principle that increased leverage can enhance returns to shareholders as long as the company generates adequate profits