Question

Capital Structure Analysis The Rivoli Company has no debt outstanding, and its financial position is given by the following data: 10% Assets (Market value = book $3,000,000 value) EBIT $500,000 Cost of equity, rs Stock price, Po $15 Shares outstanding, no 200,000 Tax rate, T (federal-plus-state) 40% The firm is considering selling bonds and simultaneously repurchasing some of its stock. If it moves to a capital structure with 35% debt based on market values, its cost of equity, rs, will increase to 12% to reflect the increased risk. Bonds can be sold at a cost, rd, of 8%. Rivoli is a no-growth firm. Hence, all its earnings are paid out as dividends. Earnings are expected to be constant over time. a. What effect would this use of leverage have on the value of the firm? 1. Increasing the financial leverage by adding debt has no effect on the firm's value. II. Increasing the financial leverage by adding debt results in an increase in the firm's value. age by adding debt results in a decrease in the firm's value. -Select- b. What would be the price of Rivoli's stock? Do not round intermediate calculations. Round your answer to the nearest cent. per share c. What happens to the firm's earnings per share after the recapitalization? Do not round intermediate calculations. Round your answer to the nearest cent. The firm -Select- its EPS by $ d. The $500,000 EBIT given previously is actually the expected value from the following probability distribution: Probability EBIT ($ 85,000) 0.10 0.20 0.40 200,000 400,000 0.20 900,000 0.10 1,285,000 Determine the times-interest-earned ratio for each probability. Use a minus sign to enter negative values, if any. Do not round intermediate calculations. Round your answers to two decimal places. Probability TIE 0.10 0.20 0.40 0.20 0.10 What is the probability of not covering the interest payment at the 35% debt level? Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

Revised Captial Structure: Bonds rd @ 8% Equity Total Market value 10,50,000 35% 19,50,000 65% 100% 30,00,000 Existing 5,00,000 Revised Workings EBIT Interest 5,00,000 A. 8% 84,000 В ЕВT 5,00,000 2,00,000 3,00,000 C A-B 4,16,000 1,66,400 Tax (@ 40%) D C*40% EAT E-C-D 2,49,600 F=E/G EPS 1.50 1.92 No. of Equity Shares @ $15 2,00,000 1,30,000 G per share WACC: % of Debt* Rate (cost of Debt) +% of Equity % Debt % of Equity Cost of Equity Cost of Debt Cost of Equity 35% Н 100% 65% 10% 12% 8% К Hence, WACC L=H*K+I*J 10% 11% a. Effect of the above Financial leverage on the value of Firm Result is lI; that is an increase in Firm's value due to 1) EPS has increased from $1.50 to $1.92 2) Value to investors (Cost of Equity) is 12%, which is more than WACC of the revised Capital structure of 11%

1.92 F above b. EPS is 0.42 F= New-Existing C. The Firm Increases its EPS by d. Times Interest Earned Ratio (TIER) Times Interest Earned Probablity EBIT/ Interest Expense Interest Expense - B (as above) TIER = EBIT/Int. ЕBIT 0.10 -85,000 84,000 -1.01 2,00,000 2.38 0.20 84,000 0.40 4,00,000 84,000 4.76 0.20 9,00,000 84,000 84,000 10.71 0.10 12,85,000 15.30 Probability of not covering interest payment @ 35% Debt 0.10