3. (6 polnsy) Highlander Enterprises is currently an all-equity firm with an esp

Question

3. (6 polnsy) Highlander Enterprises is currently an all-equity firm with an espected return of recapitalization in which it would borrow and repurchase 12%. Itis no taxes amount ofdlander bomows to the point that its debt-equity ratio is 0.50. With this the debt cost of capital is 6%, what will be the expected return of equity after this transaction? b. Suppose instead Highlander borrows to the point that its debt-equity ratio becomes 1.50. With this amount of debt, Highlander's debt will be riskier. As a result, the debt cost ofcapital will be 8%. What will be the expected return on equity in this case?

Explanation / Answer

a) Cost of levered equity, rsl = rsu + D/E x (rsu - rd)

where, rsu - unlevered cost of equity, D/E - Debt equity ratio, rd - cost of debt

rsl = 12% + 0.5 x (12% - 6%) = 15%

b) If D/E = 1.5, rd = 8%

=> rsl = 12% + 1.5 x (12% - 8%) = 18%

c) He is right. An optimal capital structure is one that minimizes cost of capital and hence, maximizes value of the firm, which in turn would lead to highest return for shareholders.

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