ExpertMedium1 markMultiple Choice
CPA · Question 44 · Area 2: Financial Statement Analysis
A company has a Debt-to-Equity ratio of 1.5. It issues new equity to pay down debt. What happens to its Solvency and ROE (assuming ROE was higher than the after-tax cost of debt)?
A company has a Debt-to-Equity ratio of 1.5. It issues new equity to pay down debt. What happens to its Solvency and ROE (assuming ROE was higher than the after-tax cost of debt)?
Answer options:
A.
Solvency Worsens; ROE Increases.
B.
Solvency Improves; ROE Decreases.
C.
Solvency Improves; ROE Increases.
D.
Solvency Worsens; ROE Decreases.
How to approach this question
1. Paying debt = Less Risk = Better Solvency. 2. Leverage magnifies returns. If you were making money on the borrowed cash, paying it back lowers your return %.
Full Answer
B.Solvency Improves; ROE Decreases.✓ Correct
B
Reducing debt improves solvency ratios (lower D/E). However, if the company was earning more on the borrowed funds than the cost of interest (positive leverage), paying off the debt will dilute the Return on Equity.
Common mistakes
Thinking safer (solvency) always means more profitable (ROE).
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