What happens to the risk associated with a stock when a company increases its leverage?

When a company increases its leverage, it takes on a greater proportion of debt relative to equity in its capital structure. This heightened level of debt influences the risk profile of the company's stock in several ways. Firstly, debt obligations require fixed repayments, meaning the company must ensure consistent cash flow to meet these payments regardless of its operational performance. If the company experiences a downturn or lower-than-expected earnings, the pressure of these fixed payments becomes significantly intense, increasing the risk of default.

Secondly, as leverage increases, the financial risk borne by equity holders rises. This is because the claims of debt holders must be satisfied before any profits can be distributed to equity holders. Increased leverage magnifies both potential returns and potential losses; while shareholders may enjoy higher returns during strong economic periods due to enhanced earnings per share, they also face greater losses during downturns since their capital is now at risk after the fixed debt obligations.

Thus, the relationship between leverage and risk is direct: increased leverage corresponds to increased financial risk for equity shareholders, making investments in such a company riskier. This is why the correct answer highlights that the risk associated with a stock increases when a company increases its leverage.