What effect does increasing financial risk have on the cost of equity?

Increasing financial risk generally leads to a higher cost of equity. This occurs because investors require a greater return for taking on additional risk. When a company takes on more debt or faces uncertainty in its financial performance, this heightens the perceived risk for equity investors, who may demand a higher return to compensate for that increased risk.

In the context of the Capital Asset Pricing Model (CAPM), the cost of equity is influenced by the equity beta, which measures the sensitivity of an investment's returns to market movements. As financial risk increases, the equity beta also tends to rise, reflecting the greater volatility and risk profile of the company's returns. Consequently, the expected return (or cost of equity) increases in order to attract investors who are willing to embrace that additional risk.

Therefore, the relationship between financial risk and the cost of equity is direct: as financial risk increases, the cost of equity also increases to compensate for the higher risk levels that investors are accepting.