Klein Cosmetics has a profit margin of 5.0%, a total assets turnover ratio of 1.5 times, a zero debt ratio and therefore an equity multiplier of 1.0, and an ROE of 7.5%. The CFO recommends that the firm borrow money, use it to buy back stock, and raise the debt ratio to 50% and the equity multiplier to 2.0. She thinks that operations would not be affected, but interest on the new debt would lower the profit margin to 4.5%. This would probably be a good move, as it would increase the ROE from 7.5% to 13.5%.

Question

Quizplus · Accepted Answer

By increasing the debt ratio and equity multiplier, Klein Cosmetics would be able to lower their cost of capital and increase their ROE. Although the profit margin would decrease due to interest expenses, the overall effect on ROE would be positive.

Klein Cosmetics Has a Profit Margin of 5