Question

2) By adding leverage, the returns of the firm are split between debt holders and equity holders, but why does equity holder risk increase as debt is added to the capital structure?

Answer 1

leverage works when we divide the capital structure into fixed and variable cost of funds. Equity holder are the variable cost of fund suppliers and actual owner of the entity. The debt holder are the fixed cost fund supplier and the creditor of the firm. When the equity holder forcast the future earning exceeding the cost of debt, they want to take the advantage of fiancial leverage. Using this leverage their cost of fund increased. And their per share earning increased. On one side this leverage can increased the income of the shareholder yet on the other side it increase the risk of defaul of payment to the debt holders. In case the firm will not earn the income above the cost of debt, then this leverage works adversaly and the per share income decrese instead of increasing. Because the firm has now fixed liabiliity of paying the interst to the debt owners. They have nothing to do with the decreased profit of the firm. So the use of finacial leverage is done when firms is assure of future earning and that too when earning rate is more than the cost of debt.