Question

Capital Structure Analysis The Rivoli Company has no debt outstanding, and its financial position is given by the following data: Assets (Market value book value) $3,000,000 EBIT $500,000 Cost of equity, rs 10% 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 11% to reflect the increased risk. Bonds can be sold at a cost, rd, of 9%. 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? I. 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. III. Increasing the financial leverage 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:

A) Select either I, II, or III.

C) Select either "increased" or "decreased".

Answer 1

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PV, FV, ANNUITY (Autosaved) - Microsoft Excel (Product Activation Failed) Review View Add-Ins File Home Insert Page Layout Formulas Data - 2x % Cut Σ AutoSum : A Calibri -11AA = = = Dr Wrap Text General BI U D A E S E E Merge & Center - $ % & ... Insert Delete Format Conditional Format Formatting as Table Styles Fill 2 Clear E Copy Paste Format Painter Clipboard HF296 Cell Styles Sort & Filter Editing Find & Select Font Alignment Number Cells 4 GXGY GZ HA HB HCHDHE HE HGHHH H 277 RIVOLI VALUE OF UNLEVERED FIRM = 15 X 200000 = 3000000 ke = k0 = 10% 278 279 280 281 282 283 NOW IF DEBT IS 35%, ke -11%, kd =9% WACC = We*ke + Wd*kd(1-t) WACC = (0.65)(11%) + (0.35)(9%)(1-0.40) WACC = 9.0400% 284 285 286 287 VALUE OF THE FIRM = FCF/WACC = EBIT(1-t)/WACC = 500000(1-0.40)/0.0904 = 3318584.07 288 289 a WHAT EFFECT WOULD THIS USE OF LEVERAGE HAVE ON THE VALUE OF THE FIRM II. INCREASING THE FINANCIAL LEVERAGE BY ADDING DEBT RESULTS IN AN INCREASE IN THE FIRM'S VALUE 290 PRICE PER SHARE VALUE OF THE FIRM/ NO OF EQUITY SHARES = 3318584.07/200000 = 16.59 291 292 b 293 294 c 295 296 297 N Rea NO OF SHARES REPURCHASED = VALUE OF DEBT/PRICE PER SHARE VALUE OF DEBT = 35% OF 3318584.07 = 1161504.42 NO OF SHARES REPURCHASED = 1161504.42/16.59 = 70000 H CAP STRU VALUE profit margin loan with points LOCK BOX DILUTION DOLLAR COST AVG EXPONPER APR CPI ear FVA LOAN OPTIONSpv, fv, annuity ferences pva 52 BO! 53 120% 1 . B 9 * 10 ENG 29-11-2019

PV, FV, ANNUITY (Autosaved) - Microsoft Excel (Product Activation Failed) Review View Add-Ins File Home Insert Page Layout Formulas Data - 2x % Cut Conditional Format Formatting as Table Styles Cell Styles Insert Delete Format Σ AutoSum : A Fill Sort & 2 Clear Filter Editing Find & Select Cells HF HG H H HI HJ 296 Calibri -11AA = = = Dr Wrap Text General E Copy Paste BIU D A E Merge & Center - Format Painter $ % & ... Clipboard Font Alignment CD Number HF313 GX GY GZ HA HB HC HDHE 293 294 C NO OF SHARES REPURCHASED = VALUE OF DEBT/PRICE PER SHARE 295 VALUE OF DEBT = 35% OF 3318584.07 = 1161504.42 NO OF SHARES REPURCHASED = 1161504.42/16.59 = 70000 297 298 REMAINING SHARES = 200000 - 70000 = 130000 299 300 ORIGINAL EPS = EBIT(1-t)/NO OF SHARES = 500000(1-0.4)/200000 = 1.5 301 302 REVISED EPS 303 EBIT 500000 304 INTEREST 104535.40 (1161504.42 x 9%) 305 EBT 395464.6 306 TAX 158185.84 307 EARNINGS 237278.76 NO OF SHARES 130000 309 REVISED EPS = 1.83 308 310 311 312 313 WHAT HAPPENS TO EARNINGS PER SHARE AFTER RECAPITALISATION THE FIRM HAS INCREASED EPS BY 1.83-1.50 = 0.33 H N CAP STRU VALUE profit margin loan with points LOCK BOX DILUTION DOLLAR COST AVG EXPONPER APR CPI ear FVA LOAN OPTIONSpv, fv, annuity ferences Red 0 (+) pva 52 53 | THE TU 120% - * * 90 ENG 2. B 9 29-11-2019

PV, FV, ANNUITY (Autosaved) - Microsoft Excel (Product Activation Failed) Review View Add-Ins File Home Insert Page Layout Formulas Data - 2x % Cut Σ AutoSum : A Calibri Dr -11AA = = = B- A B I U Wrap Text General Merge & Center - $ -% CD Number . Fill 2 Clear E Copy Paste Format Painter Clipboard GY325 Formatting as Table Styles Styles Sort & Filter Editing Find & Select Font Alignment Cells GX GYGZ HA HB HC HDHE HE HG H H HI HA 313 314 d 315 PROB (INTEREST = 104535.40) 316 EBIT TIE = EBIT/INTEREST 0.1 -110000 -1.05 0.2 200000 1.91 0.4 400000 3.83 0.2 850000 8.13 0.1 1410000 13.49 317 318 319 SO PROBABILITY OF NOT COVERING INTEREST PAYMENT IS 10% 320 321 322 323 324 325 326 327 328 329 330 331 332 333 H N CAP STRU VALUE profit margin loan with points LOCK BOX DILUTION DOLLAR COST AVG EXPONPER APR CPI ear FVA LOAN OPTIONSpv, fv, annuity ferences pva 52 53 | THE TU 120% - Rea 0 (+) D F B * * 90 ENG 29-11-2019