ACCA Advanced Financial Management (AFM) Practice Exam

What financial measure increases as a firm undertakes more debt?

1. Overall risk of the firm's operations

2. Value of equity per share

3. The variability of returns for shareholders

4. Firm's liquidity ratio

The correct answer is: The variability of returns for shareholders

The financial measure that increases as a firm undertakes more debt is the variability of returns for shareholders. As a company takes on more debt, it amplifies the potential fluctuations in its earnings and cash flows, which directly impacts the returns that shareholders can expect to receive. This phenomenon occurs due to the fixed nature of interest obligations that the company must meet; when a company has a higher level of debt, any change in revenues can lead to a proportionally larger change in net income after interest expenses are deducted. In a scenario where a company is highly leveraged, even small variations in operating performance can result in significant swings in profitability, thus increasing the uncertainty of returns. This heightened risk is often reflected in higher volatility in the company's stock price, as investors react to the increased risk associated with the firm's financial structure. The other options do not accurately reflect the direct effect of increased debt on a firm. For instance, the overall risk of the firm's operations may increase, but it is not a financial measure in the same way as variability of returns. The value of equity per share may also decrease due to increased debt, as the equity becomes riskier and may trade at a lower price. Lastly, a firm’s liquidity ratio may decrease because higher debt levels can strain