Financial leverage is believed to be favorable if:

ROI is higher than cost of debt

The correct answer is option 2- ROI is higher than cost of debt.

Financial leverage is believed to be favorable if ROI is higher than cost of debt.

The proportion of debt in the overall capital is also called financial leverage. Financial leverage is computed as D/E or D/D + E when D is the Debt and E is the Equity. As the financial leverage increases, the cost of funds declines because of increased use of cheaper debt but the financial risk increases. The impact of financial leverage on the profitability of a business can be seen through EBIT-EPS. If with higher use of debt, the difference between RoI and cost of debt increases the EPS, then it is a situation of favourable financial leverage. In such cases, companies often employ more of cheaper debt to enhance the EPS. Such practice is called Trading on Equity.