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)firm value increases with risk taking.
C)the costs of failure are borne largely by debt holders.
D)debt holders are risk seeking.

Question

Quizplus · Accepted Answer

When a firm has a large amount of debt, the costs of failure are largely borne by the debt holders. In other words, if the firm fails, the debt holders may not be able to recover the full amount they are owed. This can encourage equity shareholders to take excessive risk because they are not bearing as much of the potential costs of failure. Therefore, C is the best choice. A is incorrect because shareholders are not inherently risk seeking, and B and D are incorrect because they do not account for the role of debt in influencing risk taking.

The Presence of a Large Amount of Debt Can Encourage