Klein Cosmetics has a profit margin of 5.0%,a total assets turnover ratio of 1.5 times,no debt and therefore an equity multiplier of 1.0,and an ROE of 7.5%.The CFO recommends that the firm borrow funds using long-term debt,use the funds to buy back stock,and raise the equity multiplier to 2.0.The size of the firm (assets)would not change.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 equity multiplier to 2.0, the ROE would increase from 7.5% to 15.0% [(1.5 times 5.0%)+(7.5%)]. Even though the profit margin would decrease to 4.5%, the overall effect of the leverage increase would be positive.

Klein Cosmetics Has a Profit Margin of 5