In: Finance
5. Hardmon Enterprises is currently an all-equity firm with an expected return of 17.2% It is considering borrowing money to buy back some of its 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 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, Hardmon'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?
A) Hardmon Enterprise has an expected return of 17.2 % and the debt equity ratio is 0.50, Hardmon borrows at a cost of capital of 6 %.
So Debt equity ratio or d/e = 0.50 and Cost of debt or rd = 6%
Going by the formula return of equity = Expected return ( ru) + Debt Equity Ratio (d/e) { ru - rd}
= 17.5 % + 0.5 ( 17.5% - 6 %) = 17.5 % + 5.75 % = 23.25 %
B) Now Hardmon borrows at a point where debt equity ratio is 1.50 and now the cost of borrowing is 8% , by using the same formula we have d/e as 1.50 and rd as 8% therefore, expected return = ru + debt equity ratio ( d/e ) { ru - rd} = 17.5 % + 1.50 ( 17.5% - 8%) = 17.5% + 14.25% = 31.25 %
C) The main goal of a firm is always think on the best interest of the shareholders , where ever the a firm can maximize the value for the shareholder , they should try doing that. As the higher risk gives higher returns they should always choose a capital structure which helps them doing that. But as said higher return leads to higher risk but a firm should take that in order to yield higher return for their shareholders, so there is nothing to disagree with the statement.