medium · Principles of Finance cost-of-capital-structure

If a firm increases its use of financial leverage (debt) while its operating income (EBIT) remains constant, what is the likely effect on the firm's Return on Equity (ROE)?

1. ROE will decrease because interest expenses reduce the Net Income available to shareholders.
2. ROE will decrease because higher debt always increases the firm's total risk.
3. ROE will increase because the same operating income is spread over a smaller equity base.
4. ROE will remain unchanged because EBIT is independent of the capital structure.

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