Briefly explain the leverage effect and how it is related to the expected risk for shareholders.

The leverage effect is the impact that debt can have on a company’s expected return. This occurs as interest payments must be made in order to service any outstanding debt while equity investments do not require such obligations. As a result, companies with higher levels of debt will generate higher returns if their profits increase due to the additional income generated from loan repayments.

However, this also means that shareholders will face greater risk when investing in a company with higher leverage. This is because should those profits decline then these firms may find themselves unable to meet their financial obligations and are thus more likely to default on their loans which could drastically reduce shareholder value over time.

Overall, the leverage effect describes how debt can influence both a firm’s expected return as well as its associated risk for shareholders. Knowing this helps investors make better decisions regarding what types of companies they should invest in or avoid so that they can maximize returns while still managing risk appropriately.