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Calculating expected return from levered capital

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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 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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Solution Summary

Solution describes the steps for calculating levered cost of capital. It also discusses why or why not a capital structure that maximizes expected return for stock is in best interest of shareholders.

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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?

Cost of unlevered equity = 12%
Cost of Debt =6%
Debt equity ratio = 0.50
Expected return after this transaction
= cost of unlevered equity +D/E*(Cost of unlevered equity - cost of debt) ...

Solution provided by:
Lokesh Jain, MSc
Education
  • BEng (Hons) , Birla Institute of Technology and Science, India
  • MSc (Hons) , Birla Institute of Technology and Science, India
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