In: Finance
Hardmon Enterprises is currently an all-equity firm with an expected return of
12 %12%.
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
4 %4%.
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 debt cost of capital will be
6 %6%.
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?
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Answer:
HARDMON ENTERPRISES | ||||
a) | Expected Return | 12% | ||
Debt to Equity Ratio | 0.5 | |||
Debt Cost of Capital | 4% | |||
Formula | ||||
Expected Return on Equityof Leavered Firm=Expected retun on unleaverd firm+Debt/Equity(Expected return on Unleavered Capital-Cost of debt) | ||||
12%+.5(.12-.04) | 0.16 | |||
Expected retrun on Equity of Leavered firm= | 16% | % | ||
b) | Expected Return | 12% | ||
Debt Equity Ratio= | 1.5 | |||
Debt Cost of Capital= | 6% | |||
Formula | ||||
Expected Return on Equityof Leavered Firm=Expected retun on unleaverd firm+Debt/Equity(Expected return on Unleavered Capital-Cost of debt) | ||||
12%+1.5(.12-.06) | 0.21 | |||
Expected retrun on Equity of Leavered firm= | 21 | % | ||
c) | Yes it is the best interest of shareholder's to choose the | |||
capital structure that leads to higher expected return | ||||
on stock.Generally risk and return are worked in the | ||||
same direction.Higher the risk,higher the return.Higher | ||||
risk are compensted by higher return. | ||||