Hardy Boys Industry is currently all-equity financed and its cost of equity capi

Question

Hardy Boys Industry is currently all-equity financed and its cost of equity capital is 11%. Hardy Boys is considering a leveraged recapitalization, under which it would issue bonds and use the proceeds from the bond issue to repurchase common stock. If Hardy Boys issues bonds to the point where its debt-equity ratio is .5, the cost of debt capital will be 5%. In this case, what will be the cost of equity capital? Assume perfect markets. Hillary & Company is currently financed by 70% common stock and 30% debt. The expected return on the common stock is 14% and the yield on its bonds is 4%; these bonds are risk-free. Assuming that the bonds remain risk-free, draw a graph that shows the expected return on Hillary & Company's common stock (i.e., the cost of equity capital), the company's weighted average cost of capital, and the company's cost of debt capital for debt-equity ratios ranging from zero to three. Assume perfect markets.

Explanation / Answer

Let Debt = X, then equity be 1-X

Debt equity ratio = .5

Debt/ equity = .5

X/ (1-X) = .5 *11%

X = .33

Debt = .33

Equity = .67

Cost of equity = 7.3%

Weighed cost of capital = Cost of equity + cost of debt

= 11%

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