Because levered equity has greater risk, it should have
A an insurance policy provided to every investor.
B a greater expected return.
C a lower expected return.
The correct answer and explanation is:
The correct answer is B: a greater expected return.
Levered equity refers to equity that is financed through debt. This structure increases the potential risk and reward for equity holders. When a company uses debt to finance its operations, the return on equity can be amplified, but so can the risk. This occurs because debt obligations must be paid regardless of how the company performs, leaving equity holders to absorb any remaining gains or losses.
Given the higher risk associated with leveraging, investors typically demand a higher expected return to compensate for the possibility of losses. The rationale behind this is based on the risk-return trade-off, a fundamental concept in finance. When an investor assumes greater risk, they expect to be compensated with a higher potential return.
Leverage magnifies both gains and losses. For example, if a company’s assets generate high returns, equity holders will see even greater returns compared to an unlevered firm. However, if the company underperforms, equity holders will face more significant losses. Therefore, in a situation involving levered equity, investors expect a higher return to offset the added risk of potential losses.
If a company was unlevered (without debt), the expected return on equity would typically be lower since the financial structure is less risky. In contrast, debt holders have a fixed claim on the company’s assets, which reduces their risk but limits their upside potential, further making equity holders the higher-risk party.
Thus, because levered equity introduces more uncertainty, investors require a greater return to justify taking on that extra risk.