Question

Klein Cosmetics has a profit margin of 5.0%, a total assets turnover ratio of 1.5 times, no debt and therefore an equity multiplier of 1.0, and an ROE of 7.5%. The CFO recommends that the firm borrow funds using long-term debt, use the funds to buy back stock, and raise the equity multiplier to 2.0. The size of the firm (assets) would not change. She thinks that operations would not be affected, but interest on the new debt would lower the profit margin to 4.5%. This would probably not be a good move, as it would decrease the ROE from 7.5% to 6.5%.

A. True
B. False

Answer 1

The CFO's recommendation to increase the equity multiplier would actually result in a higher ROE, contrary to her belief that it would decrease. By applying the DuPont Identity formula, we find that the ROE would increase from 7.5% to 13.5%, not decrease to 6.5% as she predicted.

Step-by-step explanation:

The question is about evaluating whether the Chief Financial Officer's (CFO's) proposal to increase a firm's equity multiplier through debt financing would result in a higher or lower return on equity (ROE).

Given the firm's current profit margin, total assets turnover ratio, equity multiplier, and ROE, we are asked to assess the impact of borrowing funds, buying back stock to raise the equity multiplier, and consequently altering the profit margin due to interest on the new debt.

To calculate the new ROE after the CFO's recommendations, we use the DuPont Identity, which is ROE = Profit Margin x Total Asset Turnover x Equity Multiplier. Initially, the ROE is 7.5% = 5.0% x 1.5 x 1.0.

With the recommended changes, the new ROE would be 4.5% x 1.5 x 2.0, which equals 13.5%. Thus, the CFO's belief that the new debt would decrease the ROE from 7.5% to 6.5% is incorrect; in fact, it would increase the ROE to 13.5%. Therefore, the correct answer is B. False.