Positive and Negative Leverage Leverage is a double-edged sword. It can magnify gains, or magnify losses. Positive leverage occurs only when the return on borrowed funds is greater than the cost of the debt (debt yield). Negative leverage occurs when the return is less than the cost of debt. In this analysis we do not know, exactly, the return on borrowed funds so the average return for all assets is used. Thus, if the Return on Assets is greater than the cost of debt, then the leverage is considered positive and that would mean Return on Assets is being leveraged to improve Return on Equity. Conversely, if ROA is less than the cost of debt, then the leverage is considered to be negative and in that case ROA is being leveraged, but it is reducing ROE. Q26. Positive and Negative Leverage conclusion: a. The firm is positvely leveraged; increasing leverage will increase ROE. b. The firm is negatively leveraged; increasing leverage will decrease ROE. The primary problem is low ROA c. The firm is negatively leveraged; increasing leverage will decrease ROE. The primary problem is the high Cost of Debt d. Not applicable (the firm is not leveraged) Change in Equity (Net Worth) The change in a company's equity indicates how effectively the managers are building the net worth of the firm. Positive changes are always preferred and indicate the net worth is improving. Sustainable growth requires positive changes in equity. Growth in Equity improves the firm's ability to borrow. Q29. Change in Equity conclusion: a. The amount of Equity is improving due primarily to Retained Earnings. b. The amount of Equity is improving due primarily to reasons other than Retained Earnings. c. The amount of Equity is declining due primarily to Retained Earnings. d. The amount of Equity is declining due primarily to Treasury Stock (the repurchasing of shares). e. The amount of Equity is declining due primarily to reasons other than Retained Earnings or Treasury Stock