CFA Practice Question

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CFA Practice Question

Brandi's Back Yard Snacks is a highly profitable all-equity firm with a 35% tax rate. Management is considering issuing a small amount of debt and using the proceeds to retire some equity. The likely impact would be to ______

A. decrease stock price.
B. leave stock price unchanged.
C. increase stock price.
Correct Answer: C

The replacement of equity with debt will lever up the returns on equity and increase the EPS, but at the same time, the required rate of return will increase. In a world with taxes, the increase in EPS will dominate the increased cost of equity, and the stock price will rise.

User Contributed Comments 7

User Comment
shasha the eps's domination keeps stock price climbing until its peak point, after that, based on M&M theory, bankruptcy cost turns to dominate and stock price turns to go down. high bankruptcy cost requires high rate of return.
setmefree that should be the "trade-off" theory, since MM assumes no tax no bankruptcy cost
czar Please could someone advise..where in the textbooks can i find the MM theory, please.
michlam14 increased return due to increased leverage, decreased number of shares, meaning more return distributed to lower number of shares, increases EPS, increased profibility of the stock , hence increase share price
Kobe8kenji MM theory can be found in all coporate finance textbook.
Kobe8kenji except in CFA text :(
walterli quantity goes down,price goes.....?
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