Ridgefield Enterprises has total assets of $300 million. The company currently has no debt in its capital structure. The company's basic earning power is 15 percent. The company is contemplating a recapitalization where it will issue debt at 10 percent and use the proceeds to buy back shares of the company's common stock. If the company proceeds with the recapitalization, its operating income, total assets, and tax rate will remain the same. Which of the following will occur as a result of the recapitalization?
A) The company's ROA will decline.
B) The company's ROE will increase.
C) The company's basic earning power will decline.
D) Answers a and b are correct.
E) All of the above answers are correct.

Question

Quizplus · Accepted Answer

The recapitalization will increase the company's financial leverage, which will increase its ROE. However, the company's ROA will decline because the interest expense on the new debt will reduce the company's net income. The company's basic earning power will remain the same because the company's operating income, total assets, and tax rate will remain the same.

Ridgefield Enterprises Has Total Assets of $300 Million