Problem: 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.
1. 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?
2. 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?
3. 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?