The Simulate Water Level Rise/ Flooding command allows the user to simulate the water coverage/ flooding if you increase the water level by some depth over either a fixed single elevation (like 0 for sea level) or from a selected area feature, like a flood plain area. For example, if you have some coastal area selected, you can simulate increasing the sea level by some amount and see where the water would reach, taking into account any terrain features that prevent flow, like levees, buildings in the terrain, etc. This is a much better tool for modeling a change in sea levels than simply drawing water at a fixed height, which does things like fill Death Valley with water simply because it's below sea level, even though water couldn't reach there.
Another extremely important use of this function is to determine how a flood plain would expand when increased by some depth. You can select the flood plain area feature(s) prior to selecting this command, then on the Water Rise Calculation Setup dialog (pictured below) you can choose to increase the water level by some amount from the selected areas. You can easily determine what would be covered by a 100-year flood plain plus an additional 2 feet. This works by finding all points in the loaded terrain that are upstream of the selected area feature(s) and whose entry point into the area(s) is less than the provided water level increase amount.
Another possible use for this is to determine the coverage of a lake at various water levels. You can start with an area of the lake at some water level, then model the lake coverage at different levels of increase in the level.
When you select the command the dialog below appears allowing you to setup the options for the water level rise calculation, such as the amount to raise the water level by and whether to rise from the selected areas, a fixed elevation in the terrain, or both. Internally the same calculations are performed as for a watershed, so the depression fill and resolution settings described for the Generate Watershed command apply.