Hi guys What do you thinkg about this question A firm has a capital structure of 60% debt and 40% equity and a dividend payout ratio of 50%. If a surplus results from first-pass pro forma financial statements based on estimated sales growth and assuming the capital structure and dividend payout ratio are maintained, which of the following changes in assumptions would eliminate any surplus in a single step? A) The entire surplus will be used to pay down long-term debt. B) The entire surplus will be used to repurchase common stock. C) No change in assumptions is necessary. Y
i pick B
Hmm… If the capital structure shouldn’t change, the surplus has to be divided equally to debt and equity. But increasing debt changes interest payment, net income and equity. Using entire surplus to repurchasing common stock might eliminate surplus in one shot, but doesn’t the capital structure change now? We have a contra entry for treasury stock which reduces equity and changes the capital structure. Cash goes down , equity goes down and liabilities are unaffected. I would pick B , but I am not sure since the question says capital structure and dividend payout ratio are maintained.