What is the effect of increasing financial leverage on the probability of default according to the chapter?

Increasing financial leverage raises the probability of default for a firm. As a firm increases its debt financing, it becomes more obligated to meet interest and principal payments, which heightens the risk of financial distress and the likelihood of default on its debt obligations.

The chapter explains that financial leverage increases the risk of financial distress due to the contractual obligations associated with debt financing. When a firm relies more on debt, the probability of default rises because it must consistently meet its debt obligations, which can be challenging in adverse economic conditions. This is illustrated through a comparison of firms with different levels of debt financing, showing that those with higher debt have a greater likelihood of defaulting during economic downturns.