Hardmon Enterprises is currently anall-equity firm with an expected return of 18%. It is considering a leveraged recapitalization in which it would borrow and repurchase existing shares.(Assume perfect capitalmarkets.)

a. Suppose Hardmon borrows to the point that itsdebt-equity ratio is 0.50. With this amount ofdebt, the debt cost of capital is 5%. What will the expected return of equity be after thistransaction?

If Hardmon borrows to the point that itsdebt-equity ratio is 0.50 and the debt cost of capital is

5%, the expected return is .............%. (Round to one decimalplace.)

b. Suppose instead Hardmon borrows to the point that itsdebt-equity ratio is 1.50. With this amount ofdebt, Hardmon's debt will be much riskier. As aresult, the debt cost of capital will be 7%. What will the expected return of equity be in thiscase?

If Hardmon borrows to the point that itsdebt-equity ratio is 1.50 and the debt cost of capital is

7%, the expected return is .............%. (Round to one decimalplace.)

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 thisargument?

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 thisargument? (Select the best choicebelow.)

A.True, because this would also lead to the highest earnings per share.

B.True, because this will result in a higher market value for the stock.

C.False, it is in the best interest of shareholders to choose the capital structure that leads to the lowest expected return for the stock.

D.False, returns are higher because risk is higher and the return fairly compensates for the risk.