Question

Cisco currently has a market leverage ratio of 20%. However, it has decided to decrease its leverage to a new target of 15%. Currently, Cisco's expected return on equity is 14% and the expected return on its assets is 12%. Which of the following is true of its expected return on assets following the change to a new target leverage?

Group of answer choices

It will remain 12%.

It is impossible to know how the expected return on assets would change without more information on the expected return on Cisco's debt.

It will increase.

It will decrease.

Answer 1

Return on debt after putting in into the formula would be-

Return on asset=return on equity + return on debt

12= (14*80%)+(return on debt*20%)

[12-11.2/20%]=return on debt

Return on debt= 4%

since the overall return on date is much lower than overall return on equity hence decrease of the leverage ratio would ensure that overall market return of assets would be going up because decrease of leverage would be compensated with increase of equity.

Correct answer is option C) it will increase.