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.
E)this will increase profits.

Question

Quizplus · Accepted Answer

When a company has a large amount of debt, the costs of failure are largely borne by debt holders. In other words, if the company fails, the debt holders are the ones who suffer the greatest financial loss. This can encourage shareholders to take excessive risk because they bear less risk than debt holders. Shareholders may take on more risk in an attempt to earn larger returns, knowing that if the company fails, they will not face as severe consequences as debt holders.

The Presence of a Large Amount of Debt Can Encourage