What happens to Cost of Equity when a company takes on more debt?

• A. More debt reduces risk and lowers Cost of Equity
• B. Cost of Equity is unaffected by debt
• C. More debt means lower Levered Beta and lower Cost of Equity
• D. More debt means Levered Beta increases, raising Cost of Equity

Answer: (D)

The idea being tested is how financial leverage affects equity risk and the cost of equity. When a company takes on more debt, the equity holders face more financial risk because debt has fixed obligations regardless of how the business performs. This makes the equity more sensitive to changes in the firm's value, which shows up in an higher levered beta. Since cost of equity in CAPM is the risk-free rate plus the equity beta times the market risk premium, a higher levered beta pushes the cost of equity up. So, more debt increases levered beta, raising the cost of equity. Tax shields from debt can affect the overall cost of capital, but they don’t negate the fact that the cost of equity rises with higher leverage.