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, r_s, will increase to 13% to reflect the increased risk. Bonds can be sold at a cost, r_d, of 7%. Rivoli is a no-growth firm. Hence, all its earnings are paid out as dividends. Earnings are expected to be constant over time.

1. What effect would this use of leverage have on the value of the firm?
   -Select-IIIIII
   I. Increasing the financial leverage by adding debt results in a decrease in the firm's value.
   II. Increasing the financial leverage by adding debt has no effect on the firm's value.
   III. Increasing the financial leverage by adding debt results in an increase in the firm's value.
   
2. What would be the price of Rivoli's stock? Round your answer to the nearest cent.
   $   per share
   
3. What happens to the firm's earnings per share after the recapitalization? Round your answer to the nearest cent.
   The firm -Select-increaseddecreased its EPS by $   .
   
4. The $500,000 EBIT given previously is actually the expected value from the following probability distribution:

   Probability	EBIT
   0.10	- $ 90,000
   0.20	150,000
   0.40	350,000
   0.20	850,000
   0.10	1,690,000

   
   Determine the times-interest-earned ratio for each probability. 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 percent debt level? Round your answer to two decimal places.
   
   %.

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 = = V General Wrap Text Merge & Center - U S E E $ % & ... Cell Styles Insert Delete Format Calibri E Copy Paste Format Painter B I Clipboard GY140 GW GX Conditional Format Formatting as Table Styles 11 A A = D- A E Font fx GYGZ Find & Select Σ AutoSum : A Fill Sort & 2 Clear Filter Editing Alignment Number Cells HA HB HC HD HE HE HG H H H I 140 141 142 143 RIVOLI VALUE OF UNLEVERED FIRM = 15 X 200000 = 3000000 ke = k0 = 10% 144 NOW IF DEBT IS 35%, ke -13%, kd =7% WACC = We*ke + Wd*kd(1-t) WACC = (0.65)(13%) + (0.35)(7%)(1-0.40) WACC = 9.92% VALUE OF THE FIRM = FCF/WACC = EBIT(1-t)/WACC = 500000(1-0.40)/0.0992 = 3024193.55 145 146 147 148 149 150 151 152 153 154 155 156 157 158 159 160 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 PRICE PER SHARE VALUE OF THE FIRM/ NO OF EQUITY SHARES = 3024193.55/200000 = 15.12 NO OF SHARES REPURCHASED = VALUE OF DEBT/PRICE PER SHARE VALUE OF DEBT = 35% OF 3024193.55 = 1058467.74 NO OF SHARES REPURCHASED = 1058467.74/15.12 = 70000 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 BO! 53 120% Rea 1 1 + DEF * 10 ENG 27-11-2019

PV, FV, ANNUITY (Autosaved) - Microsoft Excel (Product Activation Failed) Review View Add-Ins File Home Insert Page Layout Formulas Data - 2x % Cut 11 A A = = = V Wrap Text General A E Merge & Center - $ & ... Insert Delete Format % Number Cell Styles Calibri E Copy Paste Format Painter BIU Clipboard GY156 GW GX Conditional Format Formatting as Table Styles Σ AutoSum : A Fill Sort & 2 Clear Filter Editing Find & Select Alignment Cells D Font fic GY G Z HA HB H C HD HE HE HG HH HI 156 NO OF SHARES REPURCHASED = VALUE OF DEBT/PRICE PER SHARE VALUE OF DEBT = 35% OF 3024193.55 = 1058467.74 NO OF SHARES REPURCHASED = 1058467.74/15.12 = 70000 REMAINING SHARES = 200000 - 70000 = 130000 ORIGINAL EPS = EBIT(1-t)/NO OF SHARES = 500000(1-0.4)/200000 = 157 158 159 160 161 162 163 164 165 166 167 168 169 170 REVISED EPS EBIT INTEREST EBT 500000 74092.74 (1058467.74 X 7%) 425907.26 170362.9 255544.35 130000 TAX EARNINGS NO OF SHARES REVISED EPS = 171 1.97 172 173 174 175 176 WHAT HAPPENS TO EARNINGS PER SHARE AFTER RECAPITALISATION THE FIRM HAS INCREASED EPS BY 1.97-1.50 = 0.47 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 BO! 53 120% 1 + DEF * 10 ENG 27-11-2019

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 Fill 2 Sort & 2 Clear Filter Editing Find & Select HH HI Calibri -11AA = = = Dr Wrap Text General E Copy Paste Format Painter BI U D- DA Merge & Center - $ % , :.: Formatting as Table Styles Clipboard Font C Alignment Number Styles Cells GX186 fix GW GXGY GZ HA HB HC HD HE HE HG 176 177 d PROB EBIT TIE = EBIT/INTEREST (INTEREST =74092.74) 178 0.1 -90000 -1.21 179 0.2 150000 2.02 180 0.4 350000 4.72 181 0.2 850000 11.47 182 0.1 1690000 22.81 183 184 SO PROBABILITY OF NOT COVERING INTEREST PAYMENT IS 10% 185 186 187 188 189 190 191 192 193 194 195 196 N LOAN OPTIONSpv, fv, annuity CAP STRU VALUE profit margin loan with points LOCK BOX DILUTION DOLLAR COST AVG EXPONPER APR CPI Rea ferences H ear FVA pva 52 BO! 53 120% 1 + ..lll + TE 27-11-2019