Equity in a firm with debt is called: Print
A. levered equity
B. shareholders’ equity.
C. risky equity.
D. unlevered equity.
E. risk-free equity.
The correct answer and explanation is :
The correct answer is A. levered equity.
Explanation:
Equity in a firm with debt refers to the ownership interest in the company that remains after subtracting the liabilities (debts) from the firm’s total assets. When a company takes on debt, it introduces leverage into its capital structure. The term “levered equity” describes the equity ownership in such a firm, where the firm has debt financing.
Here’s why levered equity is the correct term:
- Levered Equity: This is the term used when a firm has debt in its capital structure. The debt acts as leverage, amplifying the returns (both positive and negative) to equity holders. In the event of good performance, the return on equity will be higher than it would have been if the company had no debt. However, if the company performs poorly, the losses for equity holders can also be amplified. The presence of debt increases both the potential for higher returns and the risk.
- Shareholders’ Equity: This represents the ownership interest in a firm, which is the difference between assets and liabilities (debt). While shareholders’ equity is a component of the balance sheet, it doesn’t specifically indicate whether the firm has debt or not. Thus, it is a more general term than “levered equity.”
- Risky Equity: This term is not typically used to describe equity with debt. While leveraged equity can be riskier due to the added debt, the term “risky equity” is not a standard financial term.
- Unlevered Equity: This refers to the equity in a firm that has no debt. An unlevered firm relies solely on equity financing for its capital structure. The absence of debt means there is no financial leverage, and the equity holders face less risk of amplifying losses.
- Risk-free Equity: This is a concept that does not exist in the context of equity with debt. Equity is inherently risky due to market and company-specific factors, and the addition of debt introduces even more risk.
In conclusion, levered equity accurately describes the equity of a firm that has taken on debt, highlighting the amplified potential for both returns and risks that debt introduces.