A firm’s capital structure affects the riskiness inherent in the firms common stock and thus affects its required rate of return and stock price. The capital structure policy revolves around choosing between risk and return. Taking on increasing levels of debt increases the riskiness of the firms earning stream but results in a higher expected rate of return. High levels of risk tend to lower a stocks price, but high levels of expected rate of return tend to raise it. Therefore, striking a balance between risk and return affects the stocks price.

When a firm uses debt, or financial leverage, business risk and financial risk are concentrated on the stockholder. For example, if a firm is capitalized only with common equity, then the investors all share the business risk in proportion with their ownership of stock. However, if a firm is 50 percent levered, that is 50 percent of its assets is financed by debt, while the remaining 50 percent is financed by common equity, then the investors who put up the equity will have to bear all business and financial risk as a result of risk.

A generalization of the effects of leverage upon return on assets (ROA) and return on equity (ROE) and its effect on the stockholders can be summarized as follows:

Leverage, or debt, generally increases ROE.

The standard deviation of ROE (σ_ROE) measures the risk borne by stockholders. The standard deviation of ROA (σ_ROA) is equal to the standard deviation of ROE if the firm is not levered. With the use of debt, the standard deviation of ROE is larger than the standard deviation of ROA, this indicates that business risk is being borne by the stockholders.

The difference between the standard deviation of ROA and the standard deviation of ROE is the actual risk stockholders face. This difference measures the increased risk due to financial leverage:

Risk of financial leverage = σ_ROE – σ_ROA