Your firm has $500 million of investor-supplied capital, its return on investors

Question

Your firm has $500 million of investor-supplied capital, its return on investors' capital (ROIC) is 15%, and it currently has no debt in its capital structure (i.e., wd = 0). The CFO is contemplating a recapitalization where it would issue debt at an after-tax cost of 10% and use the proceeds to buy back some of its common stock, such that the percentage of common equity in the capital structure (wc) is 1 - wd. If the company goes ahead with the recapitalization, its operating income, the size of the firm (i.e., total assets), total investor-supplied capital, and tax rate would remain unchanged. Which of the following is most likely to occur as a result of the recapitalization? The ROA would increase. The ROA would remain unchanged. The return on investors' capital would decline. The return on investors' capital would increase. The ROE would increase.

Explanation / Answer

Correct option:

The ROE would increase.

Comments:

Due to use of debt which is cheaper cost than existing return on investor capital, will cause a increase in ROE ans excess return on debt funding by its cost will be available for equity.

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