Question

Hardmon Enterprises is currently an all-equity firm with an expected return of 12%. It is considering a leveraged recapitalization in which it would borrow and repurchase existing shares.

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 5%. What will the expected return of equity be 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 7%. What will the expected return of equity be 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,

Expected return of all equity firm (r_u) = 12%

Solution :-

Debt-equity ratio (9) = 0.50 debt Cost of Capital (82) = 5%. Expected return of equity - du t a ou-ra) lay + 0.50 (12% - 5%) = 12%. + 0.50(77) - 12 % + 3.5% = 15.50% (b) Debt-equity ratio (d) = 1.50 Debt Cost of Capital (80) = 7% Expected return of equity - Nu + a 18u - rd) = 12% + 1.50 (12%-7%) = 12% + 1.50 (5%) = 12 % + 7.5% = 19.50%

C) Since risk is higher, returns are also higher. Thus, return fairly compensates the risk.