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 30% debt based on market values, its cost of equity, r_s, will increase to 11% 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?
   I. Increasing the financial leverage by adding debt results in an increase in the firm's value.
   II. Increasing the financial leverage by adding debt results in a decrease in the firm's value.
   III. Increasing the financial leverage by adding debt has no effect on the firm's value.
   -Select-IIIIIIItem 1
   
2. What would be the price of Rivoli's stock? Do not round intermediate calculations. Round your answer to the nearest cent.
   $   per share
   
3. 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-increaseddecreasedItem 3 its EPS by $   .
   
4. The $500,000 EBIT given previously is actually the expected value from the following probability distribution:

   Probability	EBIT
   0.10	($ 110,000)
   0.20	250,000
   0.40	450,000
   0.20	850,000
   0.10	1,110,000

   
   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 30% debt level? Do not round intermediate calculations. Round your answer to two decimal places.
   
     %

Answer 1

a) With Leverage of 30% Debt, the

WACC = 0.7*11% + 0.3*7% * (1-0.4)

=8.96%

which is less than the current cost of capital of 8%

Hence the increase in firm's leverage would increase the firm value (Option I)

Also predicted by M M that value of levered firm is higher than unlevered firm in a world with taxes

b) No. of Shares repurchased = 30% of existing shares

= 30% of 200,000

= 60,000 of value $15 each

by issuing debt of $900,000 (30% of $3,000,000)

New no. of shares = 140,000

New income statement looks like

EBIT = 500,000

less : Interest (@7%) =900000* 7%

=63000

Earnings before tax = 437,000

Tax (@40%) = 174,800

Earnings after tax = 262,200

Earnings per share =262,200/140000 = $1.87 per share

As all the earnings are paid out as dividends, the share price is

Price = Earnings/ Cost of equity = 1.87/0.11 = $17.03

c) Before,

After tax earnings = $500,000* (1-0.4) =$300,000

EPS = $300,000/200,000= $1.5

Aftr EPS = $1.87

So, after recapitalisation , the firm's EPS increases by $0.37 per share

d) Times Interest Earned = EBIT/Interest = EBIT/63000

So, for various levels of EBIT, it is as shown below ;

Prob	EBIT	TIE
0.1	-110000	-1.75
0.2	250000	3.97
0.4	450000	7.14
0.2	850000	13.49
0.1	1110000	17.62

As only the first row has Times Interest Earned less than 1, probability of not covering Interest payment at 30% Debt level is 0.1 or 10%