Question

Hardmon Enterprises is currently anâ all-equity firm with an expected return of 15.2%. 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 itsâ debt-equity ratio is 0.50. With this amount ofâ debt, the debt cost of capital is 5%. What will be the expected return of equity after thisâtransaction?
b. Suppose instead Hardmon borrows to the point that itsâdebt-equity ratio is 1.50. With this amount ofâ debt, Hardmon's debt will be much riskier. As aâ result, the debt cost of capital will be 7%. What will be the expected return of equity in thisâcase?
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 thisâ argument?

Answer 1

Answer and Explanation:

The computation is shown below:

a. The expected return of equity is

= Expected return + debt to equity ratio × (expected return - debt cost to capital)

= 15.2% + 0.5 × (0.152 - 0.05)

= 20.3%

b. Now the debt cost of capital is 7%

So, the expected return of equity is

= Expected return + debt to equity ratio × (expected return - debt cost to capital)

= 15.2% + 0.5 × (0.152 - 0.07)

= 27.5%

c. As we know that if the investment has a higher return than of course it has high risk also or we can say it is compensated by high risk

So it would be best shareholder interest