Your firm is currently 100% equity financed. The CFO is considering a recapitali

Question

Your firm is currently 100% equity financed. The CFO is considering a recapitalization plan under which the firm would issue long-term debt with a yield of 9% and use the proceeds to repurchase some of its common stock. The recapitalization would not change the company's total assets, nor would it affect the firm's basic earning power, which is 15%. The CFO believes that this recapitalization would reduce the firm's WACC and increase its stock price. Which of the following would be likely to occur if the company goes ahead with the recapitalization plan? The company's ROA would increase. b. The company's ROE would decline. c. The company's earnings per share would decline. d. The company's net income would increase. e. The company's cost of equity would increase. Your firm is currently 100% equity financed. The CFO is considering a recapitalization plan under which the firm would issue long-term debt with a yield of 9% and use the proceeds to repurchase some of its common stock. The recapitalization would not change the company's total assets, nor would it affect the firm's basic earning power, which is 15%. The CFO believes that this recapitalization would reduce the firm's WACC and increase its stock price. Which of the following would be likely to occur if the company goes ahead with the recapitalization plan? The company's ROA would increase. b. The company's ROE would decline. c. The company's earnings per share would decline. d. The company's net income would increase. e. The company's cost of equity would increase. Your firm is currently 100% equity financed. The CFO is considering a recapitalization plan under which the firm would issue long-term debt with a yield of 9% and use the proceeds to repurchase some of its common stock. The recapitalization would not change the company's total assets, nor would it affect the firm's basic earning power, which is 15%. The CFO believes that this recapitalization would reduce the firm's WACC and increase its stock price. Which of the following would be likely to occur if the company goes ahead with the recapitalization plan? The company's ROA would increase. b. The company's ROE would decline. c. The company's earnings per share would decline. d. The company's net income would increase. e. The company's cost of equity would increase. The company's ROA would increase. The company's ROE would decline. The company's earnings per share would decline. The company's net income would increase. The company's cost of equity would increase. The company's ROA would increase. b. The company's ROE would decline. c. The company's earnings per share would decline. d. The company's net income would increase. e. The company's cost of equity would increase.

Explanation / Answer

ANSWER : option (e) The company's cost of equity would increase. (Since debt has tax savings as it is a business expense and earning per share will increase as debt replaces the equity partly to maintain capital unchanged and this will cause expectations of higher dividend and thus cost of equity will go up. Also, WACC is unchanged and cost of debt is lower than cost of equity, this will result in increase of cost of equity.)

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