Question

Explain why increasing financial leverage increases the risk borne by shareholders.

Answer 1

Debt is a senior security, having preference with respect to payment of return [interest] and repayment of principal. In contrast equity has the last preference and hence has the highest risk of all suppliers of capital.

When financial leverage [proportion of debt] is increased, the firm is burdened wtih a fixed cost in the form of interest and has also to make repayment of the principal, per the terms of lending. These outflows are obligations, that cannot be postponed or reduced. In other words servicing debt, entails fixed regular non-discretionary cash outflows.

When the firm makes enough profits and net cash inflows, such debt-servicing-cash-outflows do not pose any problem and the shareholders get to keep the balance. But, when the profits are on the downside, the firm may start defaulting, which, if it continues would force bankruptcy on the firm. The shareholders have then to bear the brunt of the deficiency.

Higher the debt, higher the return to the debt holders and higher the probability of bankruptcy. Bankruptcy entails bankrutpcy costs and the shareholders have to bear them also in addition to the higher risk posed by higher debt. Hence, as financial leverage is increased, the risk of the shareholders is also increased.