Risk and the Addition of Debt to the Capital Structure

Abstract

This paper investigates how the addition of debt to the capital structure of a corporation affects the risk of the stockholders. In the first instance, we will hold the size of the firm constant and substitute debt for common stock. In the second situation, we will allow firm size to change, and will accomplish the increase in size by issuing debt. For both situations, we will first observe the effect of debt on the earnings per dollar of common stock investment. The analysis could also be made using the number of shares of common stock. Since the number of shares of common stock may be changed quite arbitrarily (as, for example, by stock dividends), we want to make the measure invariant to the number of shares outstanding. We will do this by using value of common stock and value of debt. We are then computing the variance of return on common stock investment when we compute variance of earnings per dollar of common stock investment. After considering how debt affects earnings per dollar of stockholders' investment, we will investigate the effect of debt on the total earnings of the stockholders, and on the probability of a deficit.