Question

Suppose a shock to the financial system were to disproportionately hit corporate bond markets making it much harder for companies to raise new funds via bond issuance. As a result, the proportion of equity financing rises significantly.

What impact would you anticipate this would have on i) the expected return on holding stocks, and ii) the volatility of equity returns?

i) As the proportion of a company’s financing via equity versus debt rises, the company’s leverage  (Click to select)  falls  rises  does not change  . While this shift  (Click to select)  reduces  increases  leaves unchanged  the expected return to equity holders, it also  (Click to select)  reduces  increases  leaves unchanged    the standard deviation of equity returns.

i) As the proportion of a company’s financing via equity versus debt rises, the company’s leverage_____ while shift ____ the expected return to equity holders, it also _____ the standard deviation of equity returns

ii) the_____ in volatility of equity returns reflects the residual claimant status of stockholders. With a smaller proportion of bondholders to be paid ahead of equity holders, the standard deviation of equity returns is_____

Answer 1

i). As the proportion of a company’s financing via equity versus debt rises, the company’s leverage reduces while this shift reduces the expected return to equity holders, it also reduces the standard deviation of equity returns.

ii). The decrease in volatility of equity returns reflects the residual claimant status of stockholders. With a smaller proportion of bondholders to be paid ahead of equity holders, the standard deviation of equity returns is reduced/decreased.