Barette Consulting currently has no debt in its capital structure, has $500 million of total assets, and its basic earning power is 15%.The CFO is contemplating a recapitalization where it will issue debt at a cost of 10% and use the proceeds to buy back shares of the company's common stock, paying book value.If the company proceeds with the recapitalization, its operating income, total assets, and tax rate will remain unchanged.Which of the following is most likely to occur as a result of the recapitalization?

Question

Quizplus · Accepted Answer

The recapitalization involves issuing debt to repurchase equity. This increases financial leverage, which, assuming the cost of debt is less than the company's return on assets (ROA) or basic earning power, should increase the return on equity (ROE) because the company is now using cheaper debt to finance its operations instead of equity. The basic earning power remains unchanged as it is determined by operating income and total assets, which are not affected by the financing mix.

Barette Consulting Currently Has No Debt in Its Capital Structure