Leverage and the cost of capital

Recently you have been invited to the Directors meeting to decide on the future capital structure for the firm. One of your colleagues came with the following argument: Moderate borrowing doesnt significantly affect the probability of financial distress or bankruptcy. Consequently, moderate borrowing wont increase the expected rate of return demanded by stockholders.

Using the argument of M&M Proposition II The expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity ratio, suggest why this argument is wrong.