Q. Risk and Return - issue of debt?
Raising debt finance will raise the gearing and the financial risk of the company while raising equity finance will lower gearing and financial risk. Financial risk occurs since raising debt brings a commitment to meet regular interest payments whether fixed or variable. Breakdown to meet these interest payments gives debt holders the right to appoint a receiver to recover their investment. In contrast there is no authentication to receive dividends on ordinary shares only a right to participate in any dividend (share of profit) declared by the directors of a company. If profits are low then dividends are able to be passed but interest must be paid regardless of the level of profits. Moreover increasing the level of interest payments will increase the volatility of returns to shareholders since only returns in excess of the cost of debt accrue to shareholders.