Blanko Associates Co. currently is financed with 10% debt and 90% equity. Howeve

Question

Blanko Associates Co. currently is financed with 10% debt and 90% equity. However, its CFO has proposed that the firm issue new long-term debt and repurchase some of the firm's common stock. Its advisers believe that the long-term debt would require a "before-tax yield of 10%, while the firm's basic earning power is 14%. The firm's operating income and total assets will not be affected. The CFO has told the rest of the management team that he believes this move will increase the firm's stock price. If Blanko Associates Co. proceeds with the recapitalization, which of the following items are also likely to increase? Check all that apply. Return on assets (ROA) Net income Basic earning power (BEP) Cost of debt (rd) Cost of equity (rs)

Explanation / Answer

Solution: Cost of debt (rd) Cost of equity (rs) Will increases due to recapitalization process. Notes: As company issues more debt, cost of debt will increases and as in balance sheet more debt increases , risk for equity holders will also increases as result levered cost of equity also will increases Due to higher debt , there will be higher interest expense , which will Decreases the net income overall. ROA (return on assets) = net income / assets , net income will decreases as we discussed above, but assets will not change, that will result lower return on assets due to lower net income. Basic earnings power = EBIT/ Assets, both EBIT & assets does not changes , so basic earnings power will be not be affected. Please feel free to ask if anything about above solution in comment section of the question.

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