Anson Jackson Court Company (AJC)
The Anson Jackson Court (AJC) currently has $150,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6%.Its earnings before interest and taxes (EBIT) are $89,000, and it is a zero growth company.AJC's current cost of equity is 10%, and its tax rate is 25%.The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00.
-Daylight Solutions is considering a recapitalization that would increase its debt ratio and increase its interest expense.The company would issue new bonds and use 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?
A) If the plan reduces the WACC, the stock price is also likely to decline.
B) Since the plan is expected to increase EPS, this implies that net income is also expected to increase.
C) If the plan does increase the EPS, the stock price will automatically increase at the same rate.
D) Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds.
E) Since the proposed plan increases Daylight's financial risk, the company's stock price still might fall even if EPS increases.

Question

Quizplus · Accepted Answer

Increasing the debt ratio and interest expense of Daylight Solutions will increase its financial risk, which might cause its stock price to fall even if EPS increases. The other statements are incorrect. A) If the WACC (weighted average cost of capital) reduces, the stock price is likely to increase, not decline. B) Increasing EPS does not necessarily mean that net income will increase. The CFO stated that operating income will not change. C) Increasing EPS does not automatically lead to an increase in stock price. Other factors, such as risk, also affect the stock price. D) Issuing more bonds does not necessarily increase their liquidity and lower interest rates on existing bonds. It depends on market conditions and investor demand for the new bonds.