Hardmon Enterprises Is Currently An All Equity Firm ✓ Solved

Hardmon Enterprises Is Currently An All Equity Firm With An

Hardmon Enterprises is currently an all-equity firm with an expected return of 12%. It is considering borrowing money to buy back some of its existing shares, thus increasing its leverage. 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? 2. Suppose Microsoft has no debt and a WACC of 9.2%. The average debt-to-value ratio for the software industry is 5%. What would be its cost of equity if it took on the average amount of debt for its industry at a cost of debt of 6%? 3. Your firm is financed 100% with equity and has a cost of equity capital of 12%. You are considering your first debt issue, which would change your capital structure to 30% debt and 70% equity. If your cost of debt is 7%, what will be your new cost of equity?

Paper For Above Instructions

Hardmon Enterprises, currently operating as an all-equity firm with an expected return of 12%, is considering borrowing to buy back some of its existing shares. This strategy is likely to enhance its financial leverage. The analysis will explore the implications of this financial strategy through several scenarios involving different debt-equity ratios and their impact on the expected return on equity (ROE).

1. Expected Return on Equity at a Debt-Equity Ratio of 0.50

To calculate the expected return on equity after Hardmon Enterprises increases its leverage to a debt-equity ratio of 0.50, we can apply the Modigliani-Miller theorem under the assumption of no taxes. The formula for the expected return on equity (Re) is given by:

Re = Ra + (Ra - Rd) * (D/E)

Where:

  • Re = expected return on equity
  • Ra = expected return on assets (firm's return without leverage), which is 12%
  • Rd = cost of debt, which is 6%
  • D/E = debt-equity ratio, which is 0.50

Plugging the values into the formula:

Re = 12% + (12% - 6%) * 0.50 = 12% + 3% = 15%

Thus, the expected return on equity after borrowing to this point would be 15%.

2. Expected Return on Equity at a Debt-Equity Ratio of 1.50

In the second scenario, Hardmon aims for a debt-equity ratio of 1.50, where the cost of debt increases to 8%. Using the same formula as before:

Re = Ra + (Ra - Rd) * (D/E)

Where:

  • Rd = 8%
  • D/E = 1.50

Applying these values:

Re = 12% + (12% - 8%) * 1.50 = 12% + 6% = 18%

Therefore, the expected return on equity when the debt-equity ratio is 1.50 would be 18%.

3. Responding to the Manager's Argument

A senior manager suggests that shareholders would benefit from a capital structure that maximizes the expected return on equity. While it is true that leverage can enhance returns, it is essential to consider the associated risks. Increased debt levels lead to higher financial risk and can result in a volatile return pattern, which may not align with shareholder interests in the long run. Higher leverage increases the likelihood of financial distress, potentially threatening the firm’s viability. Therefore, we must strike a balance between enhancing returns and managing risks; excessive leverage can ultimately undermine shareholder value.

4. Microsoft's Cost of Equity Calculation

Shifting our focus to Microsoft, which has a WACC of 9.2% with no debt, we need to calculate its cost of equity if the company adopts the average debt-to-value ratio of 5% in the software industry. The WACC formula includes the cost of equity and cost of debt:

WACC = (E/V) Re + (D/V) Rd * (1 - Tax Rate)

Assuming no corporate taxes for simplification, and letting:

  • E = equity, V = total value (E + D), D = debt, with D/V = 0.05.
  • Re = cost of equity we are solving for, Rd = 6%.

The equity fraction E/V = 1 - D/V = 0.95.

Applying the values:

0.092 = 0.95 Re + 0.05 0.06

0.092 = 0.95 * Re + 0.003

Thus, isolating for Re:

0.092 - 0.003 = 0.95 * Re

0.089 = 0.95 * Re

Re = 0.089 / 0.95 = 0.093684, or approximately 9.37%

Hence, if Microsoft were to take on the average amount of debt for its industry, its cost of equity would increase to approximately 9.37%.

5. New Cost of Equity After Issuing Debt

Lastly, considering a firm that is currently 100% equity-financed with a cost of equity capital of 12%, if it modifies its capital structure to include 30% debt (cost of debt at 7%) and 70% equity, we can calculate the new cost of equity. We will employ the same formula:

Using the weights of debt and equity:

  • D/V = 0.30 and E/V = 0.70.

Again applying the WACC calculation method:

WACC = (E/V) Re + (D/V) Rd

Letting WACC = 12% (initial cost of equity):

0.12 = (0.70 Re) + (0.30 0.07)

0.12 = 0.70 * Re + 0.021

Subtracting 0.021 from both sides gives:

0.099 = 0.70 * Re

Re = 0.099 / 0.70 = 0.141429, or approximately 14.14%

This indicates that the new cost of equity after the issuance of debt would be 14.14%.

References

  • Modigliani, F., & Miller, M. H. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review, 48(3), 261-297.
  • Myers, S. C. (1984). The Capital Structure Puzzle. Journal of Finance, 39(3), 575-592.
  • Frank, M. Z., & Goyal, V. K. (2003). Testing the pecking order theory of capital structure. Journal of Financial Economics, 67(2), 217-248.
  • Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance (13th ed.). McGraw-Hill Education.
  • Fischer, E., Heinkel, R., & Zechner, J. (1989). Dynamic Capital Structure Choice: Theory and Tests. Journal of Finance, 44(1), 19-40.
  • Ross, S. A. (1977). The Determination of Financial Structure: The Incentive Signaling Approach. The Bell Journal of Economics, 8(1), 23-40.
  • Damodaran, A. (2012). Finance Valuation: Tools and Techniques for Determining the Value of Any Asset (4th ed.). John Wiley & Sons.
  • Bradley, M., Jarrell, G. A., & Kim, E. H. (1984). On the Existence of an Optimal Capital Structure: Theory and Evidence. Journal of Finance, 39(3), 857-878.
  • WACC: Weighted Average Cost of Capital. (n.d.). Investopedia. Retrieved from https://www.investopedia.com
  • Microsoft Corporation. (2023). Annual Report. Retrieved from https://www.microsoft.com/en-us/investor

Related Assignments