The effect of increasing financial risk through borrowing is that:
A)the risk of financial distress increases.
B)the shareholders are more assured of receiving dividends because the amount they are entitled to is lower.
C)the variability of returns to shareholders increases.
D)the risk of financial distress increases and the variability of returns to shareholders increases.

Question

Quizplus · Accepted Answer

Increasing financial risk through borrowing increases the risk of financial distress because the company now has to make interest payments and repay principal on the borrowed funds, which can become difficult if the company's earnings are insufficient. Additionally, borrowing increases the variability of returns to shareholders because any gains or losses on the borrowed funds will affect the company's overall earnings, which will then impact the returns to shareholders. Therefore, both options A and C are correct, leading to the answer of D. Option B is incorrect because increasing borrowing does not necessarily guarantee the payment of dividends, and shareholders' entitlement to dividends remains the same regardless of the amount of borrowing.

The Effect of Increasing Financial Risk Through Borrowing Is That