How does the use of debt financing affect shareholders' required rate of return on their investment?

The use of debt financing essentially increases a shareholder's required rate of return. This has to do with the fact that debt holders tend to have a higher priority when its come receiving interest/principal repayments (If debt holders are not paid regularly, they can force the company into bankruptcy procedures) compared to shareholders and their dividends (thus shareholders demand a higher risk premium).

However, another issue emerges if the amount of leverage used gets too high. Due to the effect previously mentioned, higher rate of returns are demanded as the company issues more and more debt. In order to pay those rate of returns, the company will need to conduct activities such as taking on riskier projects that can potentially yield higher returns.

With the additional risk involved with the high risk projects, shareholders need to worrying about the prospect of the company going into bankruptcy and incurring other related costs. Thus the risk premium demanded for holding shares in this scenario rises up again, in order to compensate shareholders for bearing even more risk now (remember shareholders will not receiving any recourse during bankruptcy proceedings until all legal costs and debt holders are paid).

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