Question

Daylight Solutions is considering a recapitalization that would increase its debt ratio and increase its interest expense. The company would issue new bonds and use the proceeds to buy back shares of its common stock. The company's CFO thinks the plan will not change total assets or operating income, but that it will increase earnings per share (EPS). Assuming the CFO's estimates are correct, which of the following statements is CORRECT?

a. If the plan reduces the WACC, the stock price is also likely to decline.
b. Since the plan is expected to increase EPS, this implies that net income is also expected to increase.
c. If the plan does increase the EPS, the stock price will automatically increase at the same rate.
d. Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds.
e. Since the proposed plan increases Daylight's financial risk, the company's stock price still might fall even if EPS increases.

Answer 1

Answer:

The answer is: E) Since the proposed plan increases Daylight's financial risk, the company's stock price still might fall even if EPS increases.

Explanation:

Investors are adverse to risk and if they consider that Daylight's financial risk increases, then they will require higher rates of return to compensate for the higher risks.

And even then, if EPS doesn't increase enough to satisfy investors' requirements, the stock price of Daylight will decline.