Ridgefield Enterprises has total assets of $300 million and EBIT of $45 million.
ID: 2756708 • Letter: R
Question
Ridgefield Enterprises has total assets of $300 million and EBIT of $45 million. The company currently has no debt in its capital structure. The company is contemplating a recapitalization where it will issue debt at 10 percent and use the proceeds to buy back shares of the company's common stock. If the company proceeds with the recapitalization, its operating income, total assets, and tax rate will remain the same. Which of the following will occur as a result of the recapitalization?
A. The company's ROA and ROE will increase
B. The company's ROA and ROE will decrease.Explanation / Answer
ANSWER C. The company's ROA will decrease and ROE will increase i) ROA= Net income after Interest & Tax/Total assets Consequent to Recapitalisation the numerator will decrease by the interest amt (net of taxes) Total assets remaining the same,ROA will decrease. ii) ROE= Net income after Interest & Tax/Shareholders' Equity Net income will decrease(net of taxes) but due to buy back of shares, O/s equity amt.will decrease more. Hence ROE will increase.
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