Hardmon Enterprises is currently an all-equity firm with an expected return of 0.12 per annum. It is considering a leveraged recapitalization in which it would borrow and repurchase existing shares. Assume perfect capital markets.

7(a):Suppose Hardmon borrows to the point that its debt-equity ratio is 0.6. With this amount of debt, the debt cost of capital is 0.05 per annum. What will the expected return of equity be after this transaction? (DO NOTexpress your answer in percentage)

Answer:

Question12

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7(b):Suppose instead Hardmon borrows to the point that its debt-equity ratio is 1.1. With this amount of debt, Hardmon's debt will be much riskier. As a result, the debt cost of capital will be0.1 per annum. What will the expected return of equity be in this case?(DO NOTexpress your answer in percentage)