What happens to a firm's financial risk as it increases its leverage?

When a firm increases its leverage, it borrows more capital, typically through debt financing. This action amplifies its financial risk because debt obligations must be met regardless of the firm's operational performance. If the firm experiences fluctuations in its earnings, high levels of debt can lead to increased volatility in net income, making it riskier for equity holders.

Debt carries fixed interest payments, so in times of low earnings, the firm still has to pay interest, which can create a strain on cash flows. This vulnerability to economic downturns or poor performance heightens the risk that equity holders may not receive dividends and may face greater potential losses. Moreover, if the firm does not generate enough cash to cover its debt obligations, it risks default, which could result in bankruptcy or financial distress.

In summary, an increase in leverage elevates the firm's financial risk due to increased fixed obligations and the sensitivity of equity returns to fluctuations in earnings. This is why the correct answer highlights that financial risk increases with higher leverage.