Question

Omni Consumer Products Co. currently is financed with 10% debt and 90% equity. However, its CFO has proposed that the firm issue new long-term debt and repurchase some of the firm’s common stock. Its advisers believe that the long-term debt would require a before-tax yield of 10%, while the firm’s basic earning power is 14%. The firm’s operating income and total assets will not be affected. The CFO has told the rest of the management team that he believes this move will increase the firm’s stock price. If Omni Consumer Products Co. proceeds with the recapitalization, which of the following items are also likely to increase? Check all that apply.
A. Return on assets (ROA)
B. Net income
C. Basic earning power (BEP)
D. Cost of debt (rd)
E. Cost of equity(rs)

Answer 1

Answer:

D. Cost of debt (rd)

Since more debt is taken, the interests payments or cost of debt should increase.  

E. Cost of equity (rs)

More leverage = higher risk, and higher risk = higher cost of equity.

Explanation:

Return on assets will probably decrease, because the assets should remain the same but net income should decrease.

Net income will probably decrease because the company will now pay more interests due to higher debt.

Basic earning power should remain unaffected, because EBIT and assets should not change.