How does taking on debt influence the equity discount rate?

Taking on debt influences the equity discount rate primarily by increasing the return potential while simultaneously augmenting financial risk. When a company or investment uses leverage, or debt, it can typically achieve higher returns on equity because it is using borrowed funds to finance its operations or projects. The expectation is that the returns generated from the invested funds will exceed the cost of the debt.

However, the inclusion of debt also introduces an increased level of financial risk. As debt payments must be made regardless of the investment's performance, it places pressure on cash flows. In times of economic downturn or poor investment performance, having a high level of debt can exacerbate financial difficulties, potentially leading to default. Thus, while debt can enhance returns under favorable conditions, it imposes a greater risk profile, which must be reflected in the equity discount rate.

This interplay between potential higher returns and increased risk leads to a higher equity discount rate, as investors will require greater compensation for the additional risk they are assuming by investing in a leveraged entity.