Everything else equal, and for one particular firm, in which of the following capital structures would the common stockholders have to bear the greatest amount of of business risk?
A)100 percent equity
B)25 percent equity and 75 percent debt
C)50 percent equity and 50 percent debt
D)1 percent equity and 99 percent debt
E)75 percent equity and 25 percent debt

Question

Quizplus · Accepted Answer

In option D, common stockholders have only 1 percent equity and 99 percent debt. This means that most of the financing is done through debt, which increases the business risk for the common stockholders. In case of financial distress, the debt holders have a priority claim on the assets and cash flows of the firm, which leaves little for the common stockholders. Therefore, when there is a large amount of debt in the capital structure, the common stockholders bear the greatest amount of business risk.

Everything Else Equal, and for One Particular Firm, in Which