Question

Why does adding debt to a firm's capital structure make the firm's equity more risky?

a. It increases the financial risk of the company
b. It increases the business risk of a company
c. it reduces the variability of the income to equity holders
d. it decreases the probability of financial distress
e. None of the above

Answer 1

Adding debt to a firm's capital structure increases equity risk by raising the financial risk of the company due to obligatory interest payments and potential financial distress.

Step-by-step explanation:

Adding debt to a firm's capital structure makes the firm's equity more risky because it increases the financial risk of the company. When a firm takes on debt, it commits to making regular interest payments, regardless of its financial situation. These required interest payments mean that there's less cash available for equity holders, and in the event that the firm cannot meet these obligations, it may face the risk of financial distress or even bankruptcy. This added risk makes the equity of a leveraged firm riskier than that of a firm with less or no debt.