Your firm has $500 million of total assets, its basic earning power is 15%, and it currently has no debt in its capital structure. The CFO is contemplating a recapitalization where it would issue debt at a cost of 10% and use the proceeds to buy back some of its common stock, paying book value. If the company goes ahead with the recapitalization, its operating income, total assets, and tax rate would remain unchanged. Which of the following is most likely to occur as a result of the recapitalization?
A) The ROA would increase.
B) The ROA would remain unchanged.
C) The basic earning power ratio would decline.
D) The basic earning power ratio would increase.
E) The ROE would increase.

Question

Quizplus · Accepted Answer

The recapitalization would increase the firm's financial leverage, which would increase the return on equity (ROE) as long as the return on assets (ROA) exceeds the cost of debt.

Your Firm Has $500 Million of Total Assets, Its Basic