Question

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

16.2 %16.2%.

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

5 %5%.

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

7 %7%.

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?

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Answer 1

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