Question

Hardmon Enterprises is currently an​ all-equity firm with an expected return of

12.0%.

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

6%.

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

8%.

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

ANSWER;

HARDMON ENTERPRISES
a) Expected Return 12.0%
Debt to Equity Ratio 0.5
Debt Cost of Capital 6%
Formula
Expected Return on Equityof Leavered Firm=Expected retun on unleaverd firm+Debt/Equity(Expected return on Unleavered Capital-Cost of debt)
12%+.5(.12-.06) 0.15
Expected retrun on Equity of Leavered firm= 15.0 %
b) Expected Return 12.0%
Debt Equity Ratio= 1.5
Debt Cost of Capital= 8%
Formula
Expected Return on Equityof Leavered Firm=Expected retun on unleaverd firm+Debt/Equity(Expected return on Unleavered Capital-Cost of debt)
12%+1.5(.12-.08) 0.18
Expected retrun on Equity of Leavered firm= 18.0 %
c) Yes it is the best interest of shareholder's to choose the
capital structure that leads to higher expected return
on stock.Generally risk and return are worked in the
same direction.Higher the risk,higher the return.Higher
risk are compensted by higher return.