5.) Hardmon Enterprises is currently an all-equity firm with an expected return

Question

5.) Hardmon Enterprises is currently an all-equity firm with an expected return of 12%. It is considering borrowing money to buy back some of its existing shares, thus increasing its leverage.

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, Harmon’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?

Explanation / Answer

5.

a.

Debt-equity Ratio = 0.5

For unlevered Firm, Expected Return on Equity = 12%

Cost of Debt = 6%

Expected Return on Equity after transaction = Expected Return on Equity for Unlevered Firm + Debt/Equity * (Expected Return on Equity for Unlevered Firm - Cost of Debt) = 12% + 0.5 * (12% - 6%) = 15%

b.

Debt-equity Ratio = 1.5

For unlevered Firm, Expected Return on Equity = 12%

Cost of Debt = 8%

Expected Return on Equity after transaction = Expected Return on Equity for Unlevered Firm + Debt/Equity * (Expected Return on Equity for Unlevered Firm - Cost of Debt) = 12% + 1.5 * (12% - 8%) = 21%

c.

Higher Expected Rate of Return will transmit to higher risk. So, shareholders should choose the capital structure based on their risk-return appetite.

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