Final answer:
Shareholders face increased risk when financial leverage is used due to fixed debt obligations increasing the potential for greater earnings variability. Historical examples, like the 2008 recession, demonstrate how leveraged investments can lead to substantial portfolio losses. Despite limited liability, shareholders can still lose their entire investment in such scenarios.
Step-by-step explanation:
The increase in risk to shareholders when financial leverage is introduced is best evidenced by the potential for greater variability in a company's net income and thus, its earnings per share (EPS), which can occur due to the fixed cost of debt financing. Financial leverage involves using borrowed capital (debt) to finance the purchase of assets with the expectation that the generated income from those assets will be more than the cost of borrowing. When a company has high financial leverage, it must pay interest regardless of how well it performs, which can greatly increase the risk to shareholders during economic downturns.
Throughout history, high risk levels have proven to be detrimental to an investment portfolio when economic conditions sour. The technology boom of the late 1990s saw high confidence and increased risk taking, but during the 2008 and 2009 Great Recession, over-leveraged portfolios suffered significant losses as demand for financial capital shifted to the left due to decreased confidence and economic activity. Shareholders may benefit from the limited liability associated with their investment, but they also face the possibility of losing their entire investment if the company fails due to its high debt levels.