Use the Information for the Question(s)below

question 48

Multiple Choice

Use the information for the question(s) below.
Suppose that Rose Industries is considering the acquisition of another firm in its industry for $100 million.The acquisition is expected to increase Rose's free cash flow by $5 million the first year,and this contribution is expected to grow at a rate of 3% every year thereafter.Rose currently maintains a debt to equity ratio of 1,its corporate tax rate is 21%,its cost of debt rD is 6%,and its cost of equity rE is 10%.Rose Industries will maintain a constant debt-equity ratio for the acquisition.
-Alpha Beta Corporation maintains a constant debt-equity ratio of 0.5.The total value of the firm is $30 million,and existing debt is riskless.Over the next three months,news will come out that will either raise or lower Alpha Beta's value by 10%.How will Alpha Beta adjust its debt level in response to keep its debt-equity ratio constant?

• A)Either increase by $1 million or decrease by $1 million.
• B)Either increase by $1.5 million or decrease by $1.5 million.
• C)Either increase by $3 million or decrease by $3 million.
• D)There will be no change-the debt-equity ratio will remain constant.

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Definitions:

Statement of Cash Flows

A financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents.

Long-Term Capital Gains

Profits from the sale of an asset held for more than a specified period, typically taxed at a lower rate than short-term gains.

Dividends

Payments made by a corporation to its shareholder members, typically from profits or reserves.

Ordinary Income

Income earned from conducting standard business operations, as opposed to capital gains or investment income.