ABSTRACT
§ 4-1. Previous chapters have examined how returns ought to be calculated and averaged and have summarized the relationships one might expect to find between average returns and the various risk measures encountered in the literature. Our purpose in this chapter is to focus on a risk measure that empirical research has shown to have an instrumental association with equity returns, namely, the ratio of the debt and equity with which firms finance their operating activities. Moreover, company law provides that debt holders receive preferential treatment over equity holders in the payment of income (interest and dividends) and capital. This in turn will mean that an investment in equity is more risky than an investment in debt, and so equity holders will demand a higher return on their investment as compensation for the extra risk they are required to take.
