ACCA Advanced Financial Management (AFM) Practice Exam

What occurs when a firm's debt increases?

1. The required return on equity generally decreases

2. The expected return on equity generally increases

3. Operational efficiency significantly improves

4. Tax liabilities rise proportionately

The correct answer is: The expected return on equity generally increases

When a firm's debt increases, the expected return on equity generally increases. This is primarily due to the impact of financial leverage. By increasing debt, a firm can amplify its potential returns on equity. This occurs because debt can be used to finance new investments that, if successful, generate returns greater than the cost of that debt. When a company takes on more debt, it does not change the overall risk profile of the business as perceived by investors; instead, it transfers more of the risk to equity holders. As a result, equity holders may demand a higher expected return for bearing this additional risk associated with higher leverage. The concept of the trade-off theory of capital structure supports this, indicating that while debt can initially provide favorable tax benefits, at higher levels, it can increase the overall risk and therefore requires a higher return to equity investors. In contrast, the other options don’t align with this understanding of the relationship between debt and equity returns. For instance, an increase in debt is typically associated with higher expected returns due to increased financial risk rather than a decrease in the required return on equity, which contradicts the premise behind many valuation and risk-return models. Similarly, operational efficiency does not inherently improve with an increase in debt, nor do tax liabilities necessarily