Volga Publishing is considering a proposed increase in its debt ratio, which would also increase the company's interest expense. The plan would involve issuing new bonds and using the proceeds to buy back shares of its common stock. The company's CFO thinks the plan will not change total assets or operating income, but that it will increase earnings per share (EPS). Assuming the CFO's estimates are correct, which of the following statements is CORRECT?

Question

Quizplus · Accepted Answer

Even if EPS increases, investors may still perceive an increase in financial risk due to the increased debt ratio, which could lead to a decrease in the stock price.

Answer: C
 EPS is calculated by dividing net income by the number of shares outstanding, so if EPS is expected to increase, net income must also be expected to increase.

Answers B, D, and E are incorrect.

B) If the WACC (weighted average cost of capital) decreases due to the increased debt, this would lower Volga's cost of capital and increase the stock price.
D) The stock price may not automatically increase at the same rate as the increase in EPS. Other factors such as the company's risk and growth prospects also affect the stock price.
E) The increased liquidity of the bonds may lower their required return (interest rate), but this would not necessarily lower the interest rate on the currently outstanding bonds.

Volga Publishing Is Considering a Proposed Increase in Its Debt