note: more than one answer can be correct for the first question Biddle Publishi
ID: 2646889 • Letter: N
Question
note: more than one answer can be correct for the first question
Biddle Publishing currently is financed with 10% debt and 90% equity. However, Biddle's CFO has proposed that the firm issue new long-term debt and repurchase some of the firm's common stock. Biddle's advisors believe the long-term debt would require a before-tax yield of 10%, while the firm's basic earning power (BEP) 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 Biddle proceeds with the recapitalization, which of the following items is also likely to increase? Cost of debt (rd) Return on equity (ROE) Basic earning power (BEP) Aa Aa . _ Net income Return on assets (ROA) The CFO's proposal has opened up a dialogue among the company's management team about the effects of debt financing. In particular, one manager notes that debt financing is cheaper than equity financing. He suggests that using more debt always will decrease the firm's weighted average cost of capital (WACC). Is this true?Explanation / Answer
Option 1: As the proportion of debt increases, so does the cost of debt, as the company is raising the debt for recapitalizing, the lenders feel risk of funding such company increases, so does the cost of debt.
Option 2:
As debt increases, the firms risk also increases, as risk is directly proportional to return, so does the return, at an ideal level of financial leverage, return on equity also increases.
Option 3:
As he firm's total assets and operating income is not changing there will be no change in the basic earnings power, Basic earning power is nothing but earning before interest and taxes.
Option 4:
Net income would not increase, instead it would decrease due to increase in interest expense.
Return on assets:
Return on asset =Net income/Average assets.
As the net income is decreasing, the return on assets also reduces. Since it is already mentioned that there is no change in the total assets of the firm.
Debate:
It is true that debt is cheaper than the cost of equity, because tax benefit is available on interest expense, but is not available on dividends. Also, increase in debt decreases the weighted average cost of captial.
But there is a limit or boundary beyond which, in case, the proportion of debt increases in the total financial structure of the company, the cost of equity increases, as the risk that equity holders take increases in case of increase in debt.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.