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 12% to reflect the increased risk. Bonds can be sold at a cost, r_d, of 6%. 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 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.
   -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	150,000
   0.40	550,000
   0.20	800,000
   0.10	1,010,000

   
   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)optionIoption III: increasing the financial leverage by adding debt results in an increase in the firm's value.

b)

Amount of bonds sold @6% =$3,000,000*0.30=$900,000

Amount available for repurchasing stock=$900,000

No.of stock repurchase=Amount available/current market price of stock

=900,000/15=60,000

No.of stock outstanding after repurchase=200,000-60,000=140,000

Price of stock after repurchase:

Earnings available for stock holders=

Particulars	Amount[$]
EBIT	500,000
Less: interest (900,000*6%)	(54,000)
EBT	446,000
LESS: Tax @40%	(178,400)
EAT/Earning available for stockholders/Dividend(100%payout)	267,600
Dividend per share(total dividend /no. Of stock holders)	1.911428

Price of stock :

Cost of equity(Ke)=12%

Dividend per share(D​_{​​​​​1})=$1.911428

Since there is no growth in earning ,

Price of stock =D_{​​​​​​1}/Ke=1.911428/.12=$15.92857

~$15.92857

c)

Firms earning per share before recapitalisation=

($500,000*0.60)/200,000

=,$1.5

Firms earning per share after recapitalisation =$1.911428

So firm earning per share has increased

d) Time s interest earned ratio=EBIT/INTEREST

Probability	EBIT($)	Times Interest earned ratio
0.10	(110,000)	-2.04
0.2	150,000	2.78
0.40	550,000	10.19
0.20	800,000	14.81
0.10	1,010,000	18.70

Probability of not covering interest payments @30%debt level=0.10 I.e.10%