Two firms have the same operating structure and the same operating systematic risk, ß = .8. firm 1 has 20% debt in their capital structure while Firm 2 has four units of debt for every 7 units of equity. If the tax rate faced by both firms is .4 which has the riskier equity?
A) Firm 1 because it has a higher ratio of debt to equity.
B) Neither because they both have the same ß = .8.
C) Firm 2 because it has a higher ratio of debt to equity.
D) Neither firm because systematic risk is unaffected by the financing.

Question

Quizplus · Accepted Answer

The riskiness of equity is determined by the amount of financial leverage employed by the firm. Firm 1 has a 20% debt-to-equity ratio while Firm 2 has a 4:7 debt-to-equity ratio, which translates to a 1.75 debt-to-equity ratio (4/7 = 0.57, inverse of 0.57 = 1.75). Therefore, Firm 2 has a higher amount of financial leverage, which makes its equity riskier. The systematic risk, ß = 0.8, is the same for both firms and thus does not impact the riskiness of equity.

Two Firms Have the Same Operating Structure and the Same