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Problems 475 What is the risk premium of equity in each case? What is the sensitivity of the levered equity return to systematic risk? How does its sensitivity compare to that of unlevered equity? How does its risk premium compare to that of unleyered equity? Whar is the debt-equity ratio of the firm in this case? e. What is the firm's WACC in this case? 12. Hardmon Enterprises is currently an all-equi firm with an expected return of 12%. It is con- sidering a leveraged recapitalization in which it would borrow and repurchase existing shares. a. Suppose Hardmon borrows to the point that its debt-equity ratio is 0.50. With this amount of debt, the debt cost of apital is 6%. What will the expected return of equity be 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 debe will be much riskier. As a result, the debt cost of 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 cap- ital structure that leads to the highest expected return for the stock. How would you respond to this argument? 13. Suppose Microsoft has no debt and an equity cost of capital of 9.2%. The average debt-to-value ratio for the software industry is 13%. What would its cost of equity be if it took on the average amount of debt for its industry at a cost of debt of 6%? 14 Global Pistons (GP) has common stock with a market value of $200 million and debt with a value of $100 million. Investors expect a 15% return on the stock and a 6% return on the debt. Assume perfect capital markets. a. Suppose GP issues $100 million of new stock to buy back the debt, What is the expected return of the stock after this transaction? b. Suppose instead GP issues $50 million of new debt to repurchase stock. i. If the risk of the debt does not change, what is the expected return of the stock after this transaction? ii, If the tisk of the deb increases, would the expected return of the stock be higher or lower than in part (i)? 15. Hubbard Industries is an all-equity firm whose shares have an expected return of 10%. Hub- bard does a leveraged recapitalization, issuing debt and repurchasing stock, until its debt-equity ratio is 0.60. Due to the increased risk, shareholders now expect a return of 13%, Assuming there are no taxes and Hubbard’s debt is risk free, what is the interest rate on the debt? Hartford Mining has 50 million shares that are currently trading for $4 per share and $200 mil- lion worth of debt. The debt is risk free and has an interest rate of 5%, and the
