Creditors and stockholders bear different risks because they have different rights and responsibilities.

• Creditors get pre-determined returns and principals back when due, regardless of the profitability of the firm.
• Stockholders get what is left over after all expenses, including interest paid to creditors, have been paid. In exchange for this uncertainty of returns (which is the risk that stockholders face), stockholders exercise decision-making power over the business. They can also declare what portion of the business earnings they will take out as dividends.

The use of greater amounts of debt in the capital structure can raise both the cost of debt and the cost of equity capital.

• The higher the percentage of debt, the riskier the debt, hence the higher the interest rate creditors will charge.
• In general, increasing the use of debt increases the expected rate of return, but more debt also means that the firm's stockholders must bear more risk. The cost of equity capital must be higher now than before.

Creditors have priority over stockholders in a bankruptcy proceeding. When a firm files for bankruptcy, its leverage often determines the final outcome.

• Reorganization. A firm with high financial leverage uses bankruptcy laws and protection to reorganize its capital structure to remain in business.
• Liquidation. A firm with high operating leverage cannot use such bankruptcy protection, as it would not reduce operating costs. This means that the firm's business is terminated, all the assets are sold and distributed to the holders of claims on the organization, and no corporate entity should survive. Stockholders generally lose all value in such a case, and creditors typically receive a portion of their capital.

Practice Question 1

In a corporate reorganization, ______

I. security holders may receive cash in exchange for their claims.
II. security holders may receive new securities in exchange for their claims.
III. a new corporate entity results.

Correct Answer: I, II and III

Practice Question 2

In cases of corporate liquidation, ______

I. all the assets are distributed and no corporate entity survives.
II. creditors receive distribution according to the absolute priority rule.
III. the relevant rules are provided in Chapter Seven of the Bankruptcy Act.

Correct Answer: I, II and III