Shareholders, or equity investors, are considered residual claimants because they are paid only after all other obligations have been fulfilled—this includes debt repayments, employee wages, taxes, and accounts payable. Debt is typically a cheaper financing option due to its lower risk and tax-deductible interest payments, unlike dividends, which are not deductible for the company.

Although the debt-financed firm pays interest (160 × 0.20 = 32), it uses less equity (only 40 vs. 200), resulting in a higher return on equity. The equity-financed firm earns a 30% ROE (60 ÷ 200), while the leveraged firm earns a 70% ROE (28 ÷ 40), demonstrating the magnifying effect of leverage when operating income exceeds interest costs.

When a firm uses debt (financial leverage), it reduces the equity base and adds fixed interest expenses. In a period of rising revenue, this leads to significantly higher ROE compared to an all-equity firm. However, in a downturn, the same fixed interest costs can lead to negative net income, dramatically lowering or even making ROE negative. This amplification effect is a key characteristic of financial leverage.

Unlike debt holders, equity investors are not promised fixed payments and receive returns only after all other claims have been satisfied. While they risk losing their full investment, their potential returns are theoretically unlimited, depending on the firm's performance. This high-risk, high-reward profile distinguishes equity from other investment types.

Using excess cash on hand to finance an investment avoids both the interest costs associated with debt and the dilution of ownership caused by issuing new shares. This leads to the highest ROE, provided the investment return exceeds the firm’s initial ROE. While debt financing also increases ROE due to leverage, it still incurs interest expense. Issuing equity produces the lowest ROE because it increases the equity base without leveraging the return.

Activist shareholders typically aim to unlock or enhance shareholder value, especially when they believe the company is underperforming or poorly managed. Their actions may include pressuring the board for leadership changes, restructuring, or asset sales. While environmental and social concerns are important to ESG-focused investors, activist shareholders are primarily concerned with financial performance and governance effectiveness.

A supplier that has invested in systems integrated with the company and extends short-term credit has a vested interest in the company’s financial stability. High leverage increases the risk of default on short-term obligations and raises concerns about the long-term viability of the company, which could jeopardize the supplier’s investment and ability to collect payment for goods delivered.

Good corporate governance relies on strong internal controls and oversight to ensure that the firm is managed in the best interests of shareholders. Audit committees should consist of independent directors to avoid conflicts of interest, and only shareholders—not all stakeholders—have formal governance rights such as voting on major corporate matters.

A principal-agent problem arises when managers, who are expected to act on behalf of shareholders, instead make decisions that serve their own interests—such as avoiding risk to preserve their roles or using company resources for personal gain. Mechanisms like independent board oversight and equity-based compensation help align managerial actions with shareholder goals.