Briefly explain the leverage effect and how it is related to the expected risk for shareholders.

The leverage effect is the impact that debt can have on a company’s expected return. Interest payments are required to pay off any debts, but equity investments don’t. In this way, firms with higher debt levels will see higher profits if they increase their loan repayment income.

It also means, however, that investors will be exposed to greater risks when they choose to invest in a firm with a higher level of leverage. If profits fall, these companies may not be able to pay their debts and default. This could reduce the value of their shares over time.

Overall, the leverage effect describes how debt can influence both a firm’s expected return as well as its associated risk for shareholders. Investors can make smarter decisions by knowing what to avoid and invest in, so as to maximize their returns.