Question

Hardmon Enterprises is currently an all-equity firm with an expected return of 14.3%. It is considering a leveraged recapitalization in which it would borrow and repurchase existing shares. Assume perfect capital markets. a. Suppose Hardmon borrows to the point that its debt-equity ratio is 0.50. With this amount of debt, the debt cost of capital is 4%. What will be the expected return of equity after this transaction? b. Suppose instead Hardmon borrows to the point that its debt-equity ratio is 1.50. With this amount of debt, Hardmon's debt will be much riskier. As a result, the debt cost of capital will be 6%. What will be the expected return of equity in this case? c. A senior manager argues that it is in the best interest of the shareholders to choose the capital structure that leads to the highest expected return for the stock. How would you respond to this argument?

Answer 1

Given,

Return of Unlevered equity = 14.3%

Solution :-

(a) debt - equity ratio = 0.50 debt cost of capital (&d) = 4% Now, Expected retuon enpr of equity = Sut debt-equity ratio (8u - Vd). = 14.3% + 0.50 (14.3% -4%) = 14.3%. + 0.50 (10.3%) = 14.3 7. + 5.15% = 19.45%. debt - equity ratio = 1.50 debt cost of capital (8d) = 6%. Now, Expected return of equity - Nu + debt- equity ratio (84-8d). = 14.3% + 1.50 (14.3% - 6%)

so = 14.3% + 1.50 (8.3%) = 14.3%. + 12.45% = 26.75% Here, risk is higher , so retuons are higher. The return fairly compensates the risk. Where disk is lower returns are lower and where disk is higher de returns are also higher.