Question

# 15. Hardmon Enterprises is currently an​ all-equity firm with an expected return of 17.2%. It is...

15. Hardmon Enterprises is currently an​ all-equity firm with an expected return of 17.2%. It is considering borrowing money to buy back some of its 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?

A)

Given it is a all equity firm so,

Levered cost of capital= Unlevered cost of capital + D/E*(Unlevered cost of capital - coat of debt)

=0.172+0.5*(0.172-0.06)

=22.80%

Q2)

So here she has borrowed so that d/e ratio was increased then using the same formula above,

=0.172+1.5*(0.172-0.08)

=31.00%

Q3)

Look here, We have increased the d/e ratio means we have geared to higher level upon which the risk is also increased leading to more returns aslo. So they are going in hand -in - hand like more risk more returns. Thats it!

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