ExpertHard1 markMultiple Choice
CPA · Question 37 · Area I: Business Analysis
A company has a debt-to-equity ratio of 1.5. It issues $1,000,000 of new equity and uses the proceeds to pay down $1,000,000 of debt. What is the effect on the debt-to-equity ratio and the Return on Equity (ROE)?
A company has a debt-to-equity ratio of 1.5. It issues $1,000,000 of new equity and uses the proceeds to pay down $1,000,000 of debt. What is the effect on the debt-to-equity ratio and the Return on Equity (ROE)?
Answer options:
A.
D/E Ratio Increases; ROE Increases
B.
D/E Ratio Decreases; ROE Decreases (assuming positive leverage)
C.
D/E Ratio Decreases; ROE Increases
D.
D/E Ratio Increases; ROE Decreases
How to approach this question
D/E = Debt/Equity. Numerator down, Denominator up -> Ratio down. Leverage amplifies returns. Less leverage = Less amplification.
Full Answer
B.D/E Ratio Decreases; ROE Decreases (assuming positive leverage)✓ Correct
B
Issuing equity to pay debt reduces the numerator and increases the denominator, lowering the D/E ratio. Financial leverage (debt) amplifies ROE when the company earns more on assets than the cost of debt. Removing leverage reduces this amplification, typically lowering ROE.
Common mistakes
Thinking lower debt always improves all ratios.
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