If a firm takes steps that increase its expected future Return on Equity (ROE), how is its stock price most likely to be affected, assuming all other factors remain constant?

• A. The stock price will likely decrease.
• B. The stock price will likely increase.
• C. The stock price will become more volatile but not change on average.
• D. The stock price will remain unchanged.

Answer: (B)

Verified step by step guidance

1. Understand the concept of Return on Equity (ROE): ROE measures a firm's profitability relative to shareholders' equity. It is calculated using the formula: $\frac{\mathrm{Net} \mathrm{Income}}{\mathrm{Shareholders\text{'}} \mathrm{Equity}}$. A higher ROE indicates the firm is generating more profit per dollar of equity invested.
2. Recognize the relationship between ROE and stock price: Stock prices are influenced by investors' expectations of future profitability. If a firm increases its expected future ROE, it signals higher profitability, which can attract more investors and increase demand for the stock.
3. Assume all other factors remain constant: The problem specifies that no other variables (e.g., market conditions, risk, or external economic factors) are changing. This simplifies the analysis to focus solely on the impact of increased ROE on stock price.
4. Analyze the impact of increased ROE: Higher expected future ROE suggests the firm will generate more returns for shareholders. This typically leads to higher investor confidence and increased stock demand, driving the stock price upward.
5. Conclude the most likely outcome: Based on the relationship between ROE and stock price, the stock price is most likely to increase when expected future ROE rises, assuming all other factors remain constant.