1. New York Memorial Hospital, an investor-owned enterprise, is currently 100% equity financed. The CFO is considering a recapitalization plan under which the firm would issue long-term debt with a yield of 7% and use the proceeds to repurchase common stock. The recapitalization would not change the company’s total assets, nor would it affect the firm’s basic earning power, which is currently 12%. The CFO believes that this recapitalization would reduce the CCC and increase stock price. Which of the following would also be likely to occur if the company goes ahead with the recapitalization plan?
The company’s net income would increase.
The company’s cost of equity would decrease.
The company’s ROE would increase.
The company’s ROE would decline.
2. Which of the following statements is CORRECT?
Suppose a firm’s total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt decreases from 60% of total assets to 40%. Under these conditions, the ROE will increase.
Suppose a firm’s total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt increases from 40% of total assets to 60%. Without additional information, we cannot tell what will happen to the ROE.
The Du Pont equation provides information about how operations affect the ROE, but the equation does not include the effects of debt on the ROE.
Other things held constant, an increase in the debt ratio will result in an increase in the profit margin on sales.
Suppose a firm’s total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10%, and its debt decreases from 60% of total assets to 40%. Under these conditions, the ROE will decrease.