What generally happens to the cost of equity when debt is increased?

When debt is increased, the cost of equity typically rises due to the increased financial risk that equity holders assume. As a company takes on more debt, its capital structure becomes more leveraged, increasing the potential for financial distress. Equity investors demand a higher return to compensate for this increased risk, which in turn elevates the cost of equity.

This relationship can be understood through the lens of the Modigliani-Miller theorem, which suggests that in a world with taxes, the cost of equity increases as the proportion of debt in the capital structure rises. The rationale is that with more debt, equity holders have a residual claim on the company's earnings after the debt obligations are met, making their investment riskier. Consequently, they seek a higher return for taking on that additional risk, leading to an increase in the overall cost of equity.

In contrast, other options do not accurately reflect the typical behavior of the cost of equity in response to rising debt levels.