How does the use of debt impact a firm's return on equity (ROE) compared to a firm that uses only equity financing, according to the chapter?

The use of debt can increase a firm's return on equity (ROE) if the firm earns more on its assets than the interest it pays on that debt. Leveraged firms may show higher expected returns during normal economic conditions compared to unleveraged firms, but they also face increased risk, including the potential for bankruptcy in adverse conditions.

Firms that utilize debt financing can achieve a higher return on equity (ROE) compared to those that rely solely on equity financing, provided that the returns on their assets exceed the cost of the debt. For example, a leveraged firm may report an ROE of 48% under favorable conditions, while an unleveraged firm might only achieve a 27% ROE. However, this higher ROE comes with increased risk; during poor economic conditions, the leveraged firm's ROE can drop significantly, potentially leading to bankruptcy, whereas the unleveraged firm may maintain a more stable financial position. Therefore, while debt can enhance expected returns, it also introduces greater financial risk.