Volga Publishing is considering a proposed increase in its debt ratio, which would also increase the company's interest expense. The plan would involve issuing new bonds and using 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) Since the proposed plan increases Volga's financial risk, the company's stock price still might fall even if EPS increases.
B) If the plan reduces the WACC, the stock price is also likely to decline.
C) Since the plan is expected to increase EPS, this implies that net income is also expected to increase.
D) If the plan does increase the EPS, the stock price will automatically increase at the same rate.
E) 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.

Question

Quizplus · Accepted Answer

Increasing the debt ratio increases financial risk, which makes investors demand a higher rate of return. Higher interest expense reduces net income, which could offset the benefits of returning capital to shareholders. Therefore, while the plan may increase EPS, it could also decrease the stock price. Thus, statement A is correct. The other statements are incorrect.

Volga Publishing Is Considering a Proposed Increase in Its Debt