ExpertHard1 markMultiple Choice
CPA · Question 10 · Area I: Business Analysis
A company is considering issuing $10 million in new bonds to repurchase $10 million of its own common stock. The company currently has a debt-to-equity ratio of 0.5. Assuming the interest rate on new debt is lower than the company's return on assets, what is the most likely immediate impact on the company's Return on Equity (ROE) and Times Interest Earned (TIE) ratio?
A company is considering issuing $10 million in new bonds to repurchase $10 million of its own common stock. The company currently has a debt-to-equity ratio of 0.5. Assuming the interest rate on new debt is lower than the company's return on assets, what is the most likely immediate impact on the company's Return on Equity (ROE) and Times Interest Earned (TIE) ratio?
Answer options:
A.
ROE will increase; TIE will decrease.
B.
ROE will decrease; TIE will increase.
C.
ROE will increase; TIE will increase.
D.
ROE will decrease; TIE will decrease.
How to approach this question
Analyze the components. ROE = Net Income / Equity. Equity decreases significantly. Net Income decreases slightly (due to interest). Result: ROE increases. TIE = EBIT / Interest. Interest increases. Result: TIE decreases.
Full Answer
A.ROE will increase; TIE will decrease.✓ Correct
A
1. ROE Impact: The share buyback reduces the Equity denominator. Since the cost of debt is lower than the return on assets (positive financial leverage), the remaining shareholders earn a higher return. Thus, ROE increases.<br/>2. TIE Impact: Times Interest Earned = EBIT / Interest Expense. Issuing bonds increases Interest Expense. EBIT is unaffected by financing decisions. Therefore, the denominator increases, causing the TIE ratio to decrease.
Common mistakes
Thinking TIE increases because debt is 'good'; failing to account for the reduction in equity.
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