ACME Company has Total Assets =$300 M. ACME currently has no debt, but is consid

Question

ACME Company has Total Assets =$300 M. ACME currently has no debt, but is considering a recapitalization plan that will call for issuing debt at 10% and using the proceeds to buy back common stock shares in the open market. Operating income, total assets, and tax rate will not change. Which of the following will occur as a result of the reapitalization?

A) ACME's Return on Equity (ROE) will increase and Return on Assets (ROA) will decrease.

B) ACME's stock price will increase and operating leverage decrease.

C) Neither ROE nor ROA will change subce Operating Income, total assets, and tax rate are the same.

D) Since debt financing raises financial risk, increasing the debt ratio will always increase WACC.

Explanation / Answer

The correct Answer is A.

The Return on Equity will increase because of 2 reasons:

1) The interest paid on interest is Tax deductible. Thus it reduces the interest tax expense.

2) The Net Profit would now be attributed over less equity capital. Thus ROE which Net Profit / Share Holders Equity would increase because although both Net Profit and Share Capital would reduce, percentage decrease in Share Capital will be more than percentage decrease in Net Profit.

However as the Total Assets would not change , ROA (That is Net Profit / Total Assets) would decrease as the Numerator as decreased. Note that Total assets would not change as the Cash that would increase because of Issue of Debt would decrease when the shares are repurchased.

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