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Hardmon Enterprises is considering a leverages recapitalization

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Hardmon Enterprises is currently an all-equity firm with an expected return of 12%. It is considering a leveraged recapitalization in which it would borrow and repurchase existing shares.

a. Suppose Hardmon borrow to the point that its debt-equity ratio is .50. With this amount of debt, the debt cost of capital is 6%. What will the expected return of equity be after this transaction?

b. Suppose Hardmon borrows at the debt-equity ratio is 1.50. As a result the debt cost of capital is 8%. What will the expected return of equity?

c. A manager thinks its at the best interest of the shareholder to choose the capital structure that leads to the highest expected return for the stock. What would be your response to that argument?

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a) Cost of unlevered equity = 12%
Cost of Debt =6%
Debt equity ratio = 0.50
Cost of levered equity = cost of unlevered equity +D/E*(Cost of unlevered equity - cost of debt)
=12%+0.5*(12%-6%)=15%

b) Cost of unlevered equity = 12%
Cost of Debt =8%
Debt ...

Solution Summary

The solution examines Hardmon Enterprises which consider a leverages recapitalization. The expected return of equity after the transaction is given.

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Debt-Equity Ratio

Hardmon Enterprises is currently an all equity firm with an expected return of 12%. It is considering a leveraged recapitalization in which it would borrow and repurchase existing shares.

a)Suppose Hardman borrows to the point that its debt-equity ratio is 0.50 With this amount of debt, the debt cost 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 1.5. With this amount of debt Hardman's debt will be much riskier. As a result, the debt cost of the capital will be 8%. 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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