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?
A) the roa would remain unchanged.
B) the basic earning power ratio would decline.
C) the basic earning power ratio would increase.
D) the roe would increase.
E) the roa would increase.

Question

Quizplus · Accepted Answer

The recapitalization will increase the company's financial leverage, which typically increases the return on equity (ROE) as long as the cost of debt is lower than the company's basic earning power. Since the operating income and total assets remain unchanged, the ROE is likely to increase due to the reduced equity base after the share buyback.

Barette Consulting Currently Has No Debt in Its Capital Structure