Certified Management Accountant 2026 – 400 Free Practice Questions to Pass the Exam

Lenders often require a higher interest rate from firms with high financial leverage due to the perceived increased risk associated with lending to these firms. High financial leverage means that a firm has taken on a significant amount of debt relative to equity. This increased level of debt can lead to a greater risk of default, especially during downturns in the business cycle or periods of financial instability.

When a firm is heavily leveraged, it is more vulnerable to fluctuations in cash flow and profitability, as a larger portion of its earnings must be allocated to servicing the debt. Lenders recognize that the potential for financial distress increases with higher leverage, which justifies their decision to charge a higher interest rate. This higher rate serves as compensation for the added risk, making the cost of borrowing more reflective of the firm's financial situation.

In contrast, the other options do not address the fundamental relationship between financial leverage and risk perception, such as a firm's market position, asset values, or the motivation behind loan payoffs. While those factors may play a role in lending decisions, they do not directly explain the rationale behind the higher interest rates imposed on firms facing increased risk due to substantial financial leverage.