Jones Co. currently is 100% equity financed. Thecompany is considering changing

Question

Jones Co. currently is 100% equity financed. Thecompany is considering changing its capital structure. Morespecifically, Jones’ CFO is considering a recapitalizationplan in which the firm would issue long-term debt with a yield of9% and use the proceeds to repurchase common stock. Therecapitalization would not change the company’s total assetsnor would it affect the company’s basic earning power, whichis currently 15%. The CFO estimates that the recapitalizationwill reduce the company’s WACC and increase its stockprice. Which of the following is also likely to occur if thecompany goes ahead with the planned recapitalization? (Points:4)
      The company’s net income willincrease.
       The company’searnings per share will decrease.
       The company’s cost ofequity will increase.
       The company’s ROAwill increase.
       The company’s ROEwill decrease

Explanation / Answer

The company's cost of equity will likely increase. The taking on of debt increases the riskiness of the business,which requires a higher cost of equity in order to compensate theshareholders.

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