Leverage And Expected Returns 120 100 80 60 Expected Return D 40 Expected Return

The expected return on assets is just the weighted average of the expected return on debt and the expected return on equity. As leverage increases, the expected return on equity increases and the expected return on debt remains constant (as long as debt is risk‐free) or increases as well. If both components of assets (equity and debt) are (weakly) increasing in leverage, how is it possible that the expected return on assets remains constant? See also the picture below. Ignore taxes!

Leverage and Expected Returns120%100%8060%Expected Return D40 %Expected Return E20 %Expected Return A1 %500000 1000000 1500000Face Value Zero Coupon Bond

 

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