The presence of a large amount of debt can encourage shareholders to take excessive risk because ________.
A) equity holders are risk seeking by nature
B) the costs of failure are borne largely by debt holders
C) debt holders are risk seeking
D) firm value increases with risk taking

Question

Quizplus · Accepted Answer

When a company has a large amount of debt, the costs of failure are borne largely by debt holders, not equity shareholders. This means that shareholders may be more willing to take on excessive risk in order to potentially increase their returns, knowing that if the risk does not pay off, it will be the debt holders who bear the brunt of the losses. Therefore, B is the best answer. A, C, and D are incorrect because they do not reflect the specific relationship between debt and shareholder risk-taking.

The Presence of a Large Amount of Debt Can Encourage