Practice question · Multiple choice
Equity is defined as the residual claim after creditors are paid. Why does that make shareholders the last to be paid and the first to gain?
Hints
- A firm worth 100 owes 80. Who gets what? Now make it worth 200.
- The creditor's claim is fixed; the shareholder's is what remains.
Show the answer
D. Because a residual claim takes whatever is left, if anything
Why
Fixed claim versus residual claim explains the whole risk-return structure. It is also why shareholders favour risk when the firm is near insolvency, they have little left to lose.
Practise The Accounting Equation
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