The correct answer is: D. All of the above
Leverage is the use of borrowed money to finance an investment. It can be used to increase the potential return on an investment, but it also increases the risk.
The net income approach to leverage is based on the idea that a company should use debt financing only to the extent that it can earn a return on the borrowed money that is greater than the interest rate on the debt.
The net operating income approach to leverage is based on the idea that a company should use debt financing only to the extent that it can earn a return on the borrowed money that is greater than the after-tax cost of debt.
The traditional approach to leverage is based on the idea that a company should use debt financing only to the extent that it can maintain a certain level of financial stability.
All three approaches to leverage suggest that a company should use debt financing judiciously, and that the amount of debt financing that a company should use should be based on a number of factors, including the company’s financial situation, its investment objectives, and its risk tolerance.
Here is a more detailed explanation of each approach:
- The net income approach to leverage is based on the idea that a company should use debt financing only to the extent that it can earn a return on the borrowed money that is greater than the interest rate on the debt. For example, if a company can earn a 10% return on the borrowed money, but the interest rate on the debt is only 5%, then the company should use debt financing. However, if the interest rate on the debt is 15%, then the company should not use debt financing, because the return on the borrowed money would not be greater than the cost of the debt.
- The net operating income approach to leverage is based on the idea that a company should use debt financing only to the extent that it can earn a return on the borrowed money that is greater than the after-tax cost of debt. The after-tax cost of debt is the interest rate on the debt multiplied by (1 – the tax rate). For example, if a company has a tax rate of 20% and the interest rate on the debt is 5%, then the after-tax cost of debt is 4%. If a company can earn a 10% return on the borrowed money, but the after-tax cost of debt is only 4%, then the company should use debt financing. However, if the after-tax cost of debt is 15%, then the company should not use debt financing, because the return on the borrowed money would not be greater than the cost of the debt.
- The traditional approach to leverage is based on the idea that a company should use debt financing only to the extent that it can maintain a certain level of financial stability. This level of financial stability is usually measured by the company’s debt-to-equity ratio. The debt-to-equity ratio is the ratio of a company’s debt to its equity. A high debt-to-equity ratio indicates that a company is using a lot of debt financing, and a low debt-to-equity ratio indicates that a company is using very little debt financing. A company’s debt-to-equity ratio should be based on a number of factors, including the company’s industry, its financial situation, and its investment objectives.