Question

Yellow Corp. issues 10% bonds. Not including any indirect effects on earnings, the issuance will immediately increase Yellow's:

Return on Assets Debt to Equity Ratio

A. Yes Yes

B. No No

C. Yes No

D. No Yes

Answer 1

Return on Assets Debt to Equity Ratio

D. No Yes

Working:

Lets understand with an examle.

Suppose currently we have Assets of $ 300, debt of $ 200 and Equity of $ 100 and Earning of $ 120.

Current Debt to equity

=

Debt/Equity

=

200/100

=

2.00

Current Return on assets

=

Earning/Assets

=

$     120

/

$     300

=

40%

Question says not including any indirect effect on earning.So we can assume that earning will remain same.

Now,issuance of 10% bonds means such issuance will increase debt.

Suppose $ 100 bonds issued.

Now, Revised structure will be:

Assets

$     300

+

$     100

=

$     400

Debt

$     200

+

$     100

=

$     300

Equity

$     100

+

0

=

$     100

Earning

$     120

and

Debt to equity

=

Debt/Equity

=

300/100

=

3.00

Return on assets

=

Earning/Assets

=

$     120

/

$     400

=

30%

In summarise form:

Before issuance

After issuance

Debt to equity

2.00

3.00

Return on Assets

40%

30%

So issuance of 10% bonds will increase debt to equity ratio and will not increase Return on assets (because it decreased return on assset)