Merger mania in the 1980s increased the leverage levels of many major U.S. corporations. The vice president and financial economist of Kemper Financial Services commented in The Wall Street Journal (September 18, 1990): “More leverage on the balance sheet suggests more volatile, and therefore riskier, earnings.” That same article noted that the stock market seems to have punished some of the highly leveraged firms, such as Bally Manufacturing, Beverly Enterprises, Marriott, Harcourt Brace Jovanovich, and Time Warner, but other companies that made special efforts to reduce debts, like Shoney’s and TW Holdings, hurt their profit levels. “Deleveraging is a trend that’s destined to continue and which will drag corporate profitabili¬ ty,” says the chief portfolio strategist at First Boston Corp. REQUIRED:

a. Explain why leverage would give rise to more volatile and riskier earnings.

b. In terms of solvency, earning power, financial flexibility, and liquidity, explain why the stock market might punish highly leveraged firms, and why deleveraging could drag cor¬ porate profitability.