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Because they could have gotten a higher rate of return investing in an interest bearing instrument than in equity.
It is not so much that they will expect a higher return, but that they will demand a higher return.
They can get a higher return by reducing the share price (and this is what happens in real life – if general interest rates increase then share prices tend to fall).
the amount of risk pertaining to the increased interest (liquidity risk) company has taken, this will urge shareholders to demand for higher return as per the risk they are taking investing in a geared company (assuming). then it is rationale in the market that companies do increase shareholders return.
That is not the reason.
Company borrowing (in the exam) is usually at fixed interest and therefore increased interest rates will not affect the interest payable by the company (and therefore not effect the risk).
Also, remember that the shareholders rate of return is the return that shareholders require – it is not what the company decide to give!! The shareholders get the return they require by changing the market value. It is the shareholders who determine the market value of the shares (by buying shares if they feel that the current value is too low – this will increase the market value; or by selling shares if they think the current value is too high – this will reduce the market value).
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