One of the causes of the recent financial crisis in the United States

One of the causes of the recent financial crisis in the United States has been excessive risk taking due to
underestimation of risk.

How does this relate to shareholder wealth maximization and financial leverage? Can
overestimation of risk also be detrimental?

ANSWER

Underestimation of risk can lead managers to borrow excessively to fund more and more projects. High levels of debt
require interest and principal payments which may become impossible to make if the company’s cash flows are
reduced, even for short periods of time. Overestimation of risk can also be problematic. Managers who take on too
little risk may be passing up desirable projects that could increase shareholder wealth. The principle that risk requires
a return does not mean that all risk is bad, but rather that additional risk is ok if additional expected returns are high
enough. If all risk was bad, companies would go out of business and all investors would buy U.S. Treasury bills.