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In: Finance

If a change in capital structure increases the risk both of the firm’s equity and debt,...

If a change in capital structure increases the risk both of the firm’s equity and debt, and there are no other financial claims, does it imply that the firm’s risk has increased?

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Expert Solution

Capital structure refers to an approach to finance business activities through the combination of debt and equity. Based on the combination of debt and equity the cost of capital of the firm is determined. Cost of capital refers to rate the company expects to pay to its financiers to finance its assets. If the change in capital structure leads to increase in cost of capital of the company the risk of the firm increases. The company should have optimum capital structure to reduce the cost of capital. An increase in increase of debt and equity will lead to increase in firm's risk as well as increase in debt will lead to future obligations of payment of interest and principal even if the future earnings are declining. Debt-Equity structure is one of the important approach to determine the risk of the company. Hence any increase in debt and equity of the company can lead to increase in firm's risk.

jeff jeffy answered 2 years ago
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