What is the effect of increased debt on Cost of Equity?

When a company increases its debt, it generally raises the Cost of Equity. This relationship can be understood through the concept of financial leverage and the associated risks.

As a company's debt increases, its equity holders typically perceive a higher risk because debt holders have a prior claim on the company's assets in the event of bankruptcy. This increased risk demands a higher return from equity investors, which translates to a higher Cost of Equity.

According to the Modigliani-Miller theorem, as a firm takes on more debt, the levered equity becomes riskier, leading to an increase in the required return on equity. Investors will require a higher rate of return on their investments when they believe that the potential for bankruptcy or financial distress has increased. Consequently, this higher expected return results in an increase in the Cost of Equity.

In contrast, the other options do not align with the fundamental financial principles regarding the relationship between debt and equity. A lowering or no effect on the Cost of Equity does not account for the increased risk that debt introduces, and suggesting that it eliminates the Cost of Equity overlooks the essential notion that equity holders always expect some return as compensation for their investment risk.