What is the relationship between debt levels and Cost of Equity?

• A. More debt generally lowers Cost of Equity
• B. More debt increases the company's risk, raising Cost of Equity
• C. The Cost of Equity remains unaffected by debt levels
• D. Less debt increases the risk, raising Cost of Equity

Answer: (B)

The relationship between debt levels and the Cost of Equity is fundamentally tied to the concept of financial risk. When a company takes on more debt, it increases its financial leverage, which inherently raises the risk profile of the equity holders.

As debt increases, equity holders demand a higher return to compensate for this additional risk, since their claims on the company's cash flows come after debt holders in the capital structure. Increased debt elevates the chance of financial distress, particularly in adverse economic conditions. When equity holders perceive that the company is riskier, they require a higher Cost of Equity to offset that risk.

In summary, higher levels of debt raise the company's overall risk, which in turn leads to an increase in the Cost of Equity. This relationship is a critical consideration in corporate finance, especially in the context of capital structure decisions and Modigliani-Miller theorem adjustments.