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Explain how the use of leverage can increase shareholder’s wealth.
Financial leverage refers to a company’s use of debt to increase total capital available. A firm that has a high degree of financial leverage is one that undertakes a large amount of debt relative to its equity. Financial leverage can be a powerful tool to fuel the growth of a company, but it adds additional risk. By using debt rather than increasing equity, a company can use financial leverage to generate shareholder wealth. However, if it fails, shareholder value will actually be reduced by increased interest expense and credit problems. Another type of leverage is operating leverage. Degree of operating leverage (DOL) refers to a complex ratio that analyzes the effect of operating leverage on a firm’s earnings before interest and taxes.