If a firm increases the proportions of debt and preferred stock that are contained in its capital structure, its _____.
A)financial risk will increase
B)business risk will decrease
C)tax liability will increase
D)operating leverage will decrease
E)financial leverage will decrease

Question

If a firm increases the proportions of debt and preferred stock that are contained in its capital structure, its _____. 
A)financial risk will increase
B)business risk will decrease
C)tax liability will increase
D)operating leverage will decrease
E)financial leverage will decrease

Quizplus · Accepted Answer

Increasing the proportion of debt and preferred stock increases the financial leverage of the firm, which in turn increases the financial risk. This is because debt requires regular interest payments and preferred stock requires fixed dividend payments, which must be paid regardless of whether the company earns a profit or not. This increases the company's fixed financial expenses, which makes it more difficult for the company to cover its expenses during times of low profitability.

If a Firm Increases the Proportions of Debt and Preferred