8. Financial risk refers to the extra risk borne by stockholders as a result of

Question

8. Financial risk refers to the extra risk borne by stockholders as a result of a firm's use of debt as compared with their risk if the firm had used no debt. a. True b. False
8. Financial risk refers to the extra risk borne by stockholders as a result of a firm's use of debt as compared with their risk if the firm had used no debt. a. True b. False
8. Financial risk refers to the extra risk borne by stockholders as a result of a firm's use of debt as compared with their risk if the firm had used no debt. a. True b. False

Explanation / Answer

answer :- True

Explanation:-   

1. The firm which is financed with both debt and equity is called ''levered firm'' and the firm financed solely with equity is ''unlevered firm''

2.The profits of the company may drop due to drop in sales,selling price, economic conditions etc....But even on reduced profits also company has to pay the same interest to the debt which have great impact on earning per share(EPS).

Let debt taken $50lakhs @ 10% interest and number of equity shareholders be 1000, tax @ 15% and Consider 2 situations

Situation 1:-

Earnings before interest and tax(EBIT) = $ 10 lakhs

less:   interest ($50lakh * 10%) = $ 5lakhs

Earnings before tax(EBT) = $ 5Lakhs

less: tax ($5lakh * 15%) = $ 0.75lakhs

Earnings after tax(EAT) = $ 4.25Lakhs

No.of share holders = 1000

Earning per share(EPS) = $425 ($4.25Lakhs / 1000)

Situation 2:-   

Earnings before interest and tax(EBIT) = $ 7 lakhs

less:   interest ($50lakh * 10%) = $ 5lakhs

Earnings before tax(EBT) = $ 2Lakhs

less: tax ($2lakh * 15%) = $ 0.3lakhs

Earnings after tax(EAT) = $ 1.7Lakhs

No.of share holders = 1000

Earning per share(EPS) = $170

By considering both the situations there is no change in the payment of interest to debt but due to reduction in EBIT , EPS was effected.

3. beta () is the the risk of firm with market if the = 1.2 then if market changes by 1% my Earnings vary by 1.2%.

4. Since risk of levered firm is higher than unlevered firm levered > unlevered

Example:-

consider 2 situations

situation1;-

Firm not having debt fully financed through equity

BALANCESHEET

liability proportion      weighted proportion asset  

equity 1 1.2 1.2 asset   1.2

debt 0 0 0        

total 1.2 1.2

Situation2:-

if firm financed equally with debt and equity which is levered firm

BALANCESHEET

liability  proportion         weighted proportion asset  

equity 0.5 2.4 (balancingfigure) 1.2 asset   1.2

debt 0.5 0 (note) 0      

total 1.2   1.2

note:-

The debt holders wont be having any risk what ever the situation they have to be paid their agreed interest. hence their beta will be 0. so their risk has to be taken by equity holders hence their beta increased from 1.2 to 2.4

this proves

Financial risk refers to the extra risk borne by stockholders as a result of a firm's use of debt as

compared with their risk if the firm had used no debt.

Related Questions

Navigate

• Browse (All)
• Browse 8
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.