In a leveraged buyout, how does high leverage influence bankruptcy risk and financial flexibility?

• A. High leverage increases bankruptcy risk and reduces financial flexibility
• B. High leverage increases financial flexibility
• C. Bankruptcy risk is unaffected
• D. Leverage does not affect risk

Answer: (A)

High leverage means a company carries a large amount of debt relative to equity, which creates fixed debt-service obligations that must be paid from operating cash flow. If the business earns less than expected or faces a downturn, those mandatory payments can’t be skipped, raising the probability of financial distress or bankruptcy. At the same time, debt covenants and the need to service debt constrain management’s options, reducing financial flexibility to fund growth, react to opportunities, or weather shocks. So, the combination of higher bankruptcy risk and tighter flexibility is a direct consequence of heavy debt in an LBO structure.