Blanton Corporation increased its financial leverage during 2010 by ta

Blanton Corporation increased its financial leverage during 2010 by taking out a loan and using the proceeds to
buy back common stock. At the end of 2010, the corporation reported higher earnings per share and higher
return on equity.

However, its stock price declined. Discuss why this may happen.

ANSWER

Financial leverage is a double-edged sword. While it may result in an increase in ROE and EPS, it may also increase
the riskiness of the company. Given the principal of a risk-return trade-off, the increase in return may not be sufficient
to offset the increase in risk, and the price may decrease. Also, stock prices are determined by many factors beyond
accounting information, such as competitors’ actions, the level of interest rates, consumer confidence, etc. Therefore,
even if the financial leverage by itself had a positive impact on the stock price, other unidentified factors may have
caused the price to go down.