Mergers & Inquisitions (M&I) 400 Practice Exam

When a company takes on additional debt, the Cost of Equity increases due to the higher risk associated with increased leverage. This phenomenon is primarily explained by the Modigliani-Miller theorem, which suggests that in a world with taxes, as a company takes on more debt, it becomes riskier for equity holders because debt holders have a priority claim on the company's assets in case of bankruptcy. Consequently, equity holders will demand a higher return to compensate for this increased risk. As the company becomes more leveraged, the financial risk increases. Equity investors recognize that with more debt, the variability of returns on equity also increases; if the company does well, equity holders could receive higher returns, but if things go poorly, they could suffer significant losses. Therefore, to attract investors, the company must compensate for this additional risk by raising its Cost of Equity. In summary, taking on additional debt raises the Cost of Equity due to increased financial risk for equity holders, which aligns perfectly with the correct answer.