How can the cost of equity be increased?

The cost of equity can be increased by an increase in equity risk premiums. The equity risk premium represents the extra return that investors require for taking on the additional risk of investing in equities over risk-free assets. When the perceived risk associated with equities rises—due to factors like market conditions or specific risks related to a company or industry—investors demand a higher return to compensate for that increased risk.

This effectively raises the cost of equity, as the return required by investors increases. A higher equity risk premium indicates greater expected volatility or lower investor confidence in the market, leading to the need for a larger return to justify the investment in equity.

In contrast, other options do not directly lead to an increase in the cost of equity. Lowering risk-free rates would typically decrease the cost of equity, as the required returns would be lower when investors have more stable and lower-risk return options. Reducing debt in the capital structure can lower the overall risk of the firm, potentially reducing the cost of equity too, as less debt can lead to lower financial risk. Meanwhile, decreasing market volatility tends to be associated with a lower perceived risk, subsequently reducing, rather than increasing, the cost of equity.