ACCA Advanced Financial Management (AFM) Practice Exam

What is meant by financial risk in the context of a firm's capital structure?

1. Risk associated with operational inefficiencies

2. Risk to shareholders resulting from the use of debt

3. Risk of market fluctuations affecting share price

4. Risk tied to regulatory changes affecting the business

The correct answer is: Risk to shareholders resulting from the use of debt

Financial risk primarily refers to the uncertainty and potential adverse effects that arise from a firm's use of debt in its capital structure. When a company takes on debt to finance its operations or growth, it commits to fixed payments in the form of interest and principal repayments, regardless of its revenue performance. This financial leverage can amplify returns, but it also increases the risk to shareholders because the obligation to service debt persists even in difficult economic conditions. If a firm's earnings do not meet expectations or decline, the burden of debt can jeopardize the firm's ability to pay its obligations. In such scenarios, shareholders face increased risk since the firm may have less flexibility to reinvest in growth opportunities, distribute dividends, or weather downturns. This potential for greater volatility in returns due to the fixed nature of debt repayments epitomizes financial risk in the context of capital structure. In contrast, the other options relate to different types of risks that do not specifically pertain to the consequences of using debt in a company's financing strategy. Operational inefficiencies deal with management and operational risks, market fluctuations pertain to external economic factors unrelated to capital structure, and regulatory changes focus on compliance risks that are not inherently linked to a firm's financial leverage.