About Lesson
Leverage means the use of loans to finance the capital requirements of a firm. Debt financing is usually considered as a less risky form of financing from the point of view of capital providers, as it carries fixed payments. Due to lesser risk, the debt instruments generally carry a lesser cost. Therefore, the element of debt in the capital structure of a company reduces the overall average cost of capital to the company. This provides the leverage effect to the companies.
In this chapter, we study the leverage effect due to the presence of debt in the capital, the risks associated with them, and the optimal amount that balances the risk-return on the capital. We also discuss here the measures of operating and financial leverage.