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1) Max Co. presently is 100 percent equity financed. Company is considering changing its capital structure. More specially, Max CFO is considering recapitalization plan in which a firm would issue long-term debt with the yield of 9 percent and use proceeds to repurchase common stock. Recapitalization would not change firm’s total assets nor would it affect firm's basic earning power, which is presently 15 percent. The CFO estimates that recapitalization will decrease the firm's WACC and increase its stock price. Which of the following is also likely to happen if the firm goes ahead with planned recapitalization?

a. The firm’s net income will increase.
b. The firm's earnings per share will decrease.
c. The firm's cost of equity will increase.
d. The firm's ROA will increase.
e. The firm's ROE will decrease.

2) Which of the following statements is right?

a. As debt financing raises firm's financial risk, increasing a company's debt ratio will always increase company's WACC.
b. As debt financing is cheaper than equity financing, increasing a company's debt ratio will always decrease the company's WACC.
c. Increasing firm's debt ratio will typically decrease the marginal costs of both debt and equity financing; though, it still may increase the firm's WACC.
d. Statements a and c are right.
e. None of the statements above are right.

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  • Category:- Accounting Basics
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