Royal Beds Inc. is a company that sells mattresses and wooden beds. Its capital structure indicates that it a highly leveraged company. Which of the following scenarios would Royal Beds have to encounter in case it was hit by a financial crisis like recession?
A) Recession would bring about a relief in the payment of the principal amount and interest on the debts.
B) It would desperately be looking for ways to replace most of its debt with equity.
C) It would be hit by the realization that the use of leverage can never decrease its return on equity.
D) Recession would increase the retained earnings of the firm. As the recession of 20072008 loomed over both large and small businesses,

Question

Royal Beds Inc. is a company that sells mattresses and wooden beds. Its capital structure indicates that it a highly leveraged company. Which of the following scenarios would Royal Beds have to encounter in case it was hit by a financial crisis like recession?
A) Recession would bring about a relief in the payment of the principal amount and interest on the debts.
B) It would desperately be looking for ways to replace most of its debt with equity.
C) It would be hit by the realization that the use of leverage can never decrease its return on equity.
D) Recession would increase the retained earnings of the firm. As the recession of 2007­2008 loomed over both large and small businesses,

Quizplus · Accepted Answer

A highly leveraged company like Royal Beds Inc. would be vulnerable in a financial crisis like a recession. In such a crisis, access to credit becomes difficult, and the company could struggle to meet its debt servicing obligations. In such a scenario, the company would likely try to reduce its leverage by replacing debt with equity, which would provide some relief from debt servicing costs. Option A is incorrect because in a recession, debt servicing costs could increase, and relief would only come if the company renegotiates with its creditors. Option C is incorrect because leverage can increase the return on equity, but it also increases the risk, making the company vulnerable in a downturn. Option D is incorrect because a recession would likely result in reduced earnings, which could reduce retained earnings.