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 cost of debt is 6%. 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 cost of debt will be 8%. 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(hint: risk-reward tradeoff)?

Answer 1

a). Cost of unlevered equity = 12%

Cost of debt (kd) = 6%

Debt/Equity ratio (D/E) = 0.50

Cost of levered equity = cost of unlevered equity + (D/E)*(cost of unlevered equity - kd)

= 12% + 0.5*(12%-6%) = 15%

b). New cost of debt (kd) = 8%

Cost of levered equity = 12% + 1.5*(12%-8%) = 18%

c). Higher return comes with higher risk as the return will always compensate for the associated risk. That is the risk and reward trade-off. So, a company needs to match its return expectation with its risk appetite.