Hardmon Enterprises Is Currently An All-Equity Firm 306693

5 Hardmon Enterprises Is Currently An All Equity Firm With An Expecte

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?

6. 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%?

7. 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 instruction

The strategic management of capital structure plays a pivotal role in balancing risk and return for firms. It influences the overall cost of capital and impacts shareholder value. This paper explores various scenarios involving capital structure adjustments, mainly focusing on leverage effects, using examples from Hardmon Enterprises, Microsoft, and theoretical frameworks. The core principle guiding decision-making is how leverage impacts the expected return on equity and the firm's weighted average cost of capital (WACC).

Hardmon Enterprises' current position as an all-equity firm with a 12% expected return sets the stage. The firm’s potential leverage increases through borrowing, which alters its risk profile and expected return on equity. When Hardmon borrows to achieve a debt-equity ratio of 0.50, with a debt cost of capital at 6%, the expected return on equity can be calculated using the Modigliani-Miller framework with corporate taxes:

Re = R0 + (D/E) * (R0 - Rd)

Where:

  • Re = expected return on equity after leverage
  • R0 = current unlevered equity return (12%)
  • D/E = debt-equity ratio (0.50)
  • Rd = cost of debt (6%)

Substituting the values:

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

Thus, the expected return of equity after assuming a debt-equity ratio of 0.50 is 15%. When Hardmon increases leverage further to a debt-equity ratio of 1.50, and with a higher debt cost of 8%, a similar calculation yields:

Re = 12% + 1.50 (12% - 8%) = 12% + 1.50 4% = 12% + 6% = 18%

This demonstrates the leverage effect — higher debt levels increase the expected return on equity due to increased risk, but also heighten financial risk, potentially impacting the firm's stability.

However, financial theory emphasizes that maximizing expected equity returns might not always align with shareholder wealth maximization, especially if excessive leverage jeopardizes the firm’s financial health. Increased risk can lead to higher expected returns but also higher volatility, which might negatively influence the firm's valuation.

Regarding Microsoft, with no debt and a WACC of 9.2%, industry data suggests that taking on an average debt ratio of 5% at a cost of debt of 6% will impact the firm's cost of equity. Using the Modigliani-Miller theorem without taxes for simplicity:

WACC = E/V Re + D/V Rd

Re is the unknown, with:

  • WACC = 9.2%
  • Debt ratio (D/V) = 0.05
  • Equity ratio (E/V) = 0.95
  • Rd = 6%

Re = (WACC - D/V Rd) / (E/V) = (0.092 - 0.05 0.06) / 0.95 = (0.092 - 0.003) / 0.95 ≈ 0.089 / 0.95 ≈ 0.0937 or 9.37%

This calculation indicates that Microsoft's cost of equity would modestly increase to approximately 9.37% upon adopting industry-average leverage.

Finally, for a firm initially financed solely with equity at a 12% cost of equity and contemplating issuing debt to establish a capital structure of 30% debt and 70% equity with a 7% cost of debt, the new cost of equity can be derived from the weighted average and rearranged to solve for Re:

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

Re = (WACC - D/V * Rd) / (E/V)

Assuming the WACC remains similar or adjusted accordingly, with D/V = 0.30, E/V = 0.70, Rd = 7%, and WACC calculated based on the new structure, the new Re can be estimated. Applying the formula:

Re = (WACC - 0.30 * 0.07) / 0.70

If the firm’s WACC is projected to remain around 12% (approximate, considering marginal change), plugging in the values:

Re = (0.12 - 0.021) / 0.70 ≈ 0.099 / 0.70 ≈ 14.14%

This suggests the firm's cost of equity would increase from 12% to approximately 14.14% due to the introduction of debt, reflecting the higher financial risk retained by equityholders.

In summary, leveraging through debt increases the expected return on equity due to heightened financial risk. However, the decision to leverage must also consider the firm's ability to service debt, potential agency costs, and the impact on firm stability. Shareholder interests are best served by a balanced approach that maximizes firm value rather than focusing solely on the highest expected return, which can lead to excessive risk-taking and potentially damaging consequences.

References

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