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 12% to reflect the increased risk. Bonds can be sold at a cost, rd, 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.

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.

What would be the price of Rivoli's stock? Do not round intermediate calculations. Round your answer to the nearest cent.

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 (increase/decrease) its EPS by $ .

The $500,000 EBIT given previously is actually the expected value from the following probability distribution:

Probability EBIT

0.10 - $ 75,000

0.20 200,000

0.40 400,000

0.20 800,000

0.10 1,475,000

Determine the times-interest-earned ratio for each probability. 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 percent debt level? Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

Effect of use of this leverage on the firm

WACC= .35*6% + .65*12%*(1-.40)

WACC= .021+ .0468=.0678

Value of the firm= EBIT *(1- Taxes)/WACC

Value of the firm= 500000(1-40%)/.0678

Value of the firm= $4424779

Increase in the financial leverage by adding debt results in increase in firm’s value.

Price of stock

Price of stock= $4424779/200000 shares= 22.12

Impact on firm’s earnings per share after recapitalization

EPS with no debt= EBIT- Interest- taxes/number of shares

EPS with no debt= $500000-0-40%of 500000/200000

EPS with no debt=300000/200000= 1.5

EPS with 35% debt=500000- 6%*35% of $4424779- taxes/200000

EPS with 35% debt=500000-92920-taxes/200000

EPS with 35% debt=407080- 40% tax/200000

EPS with 35% debt=407080-162832/200000

EPS with 35% debt=1.22

The EPS has decreased from 1.5 to 1.22= .28

Times interest earned ratio

TIE= EBIT/Interest where interest is $162832

Probability	EBIT	TIE
.10	-$75000	-.46
.20	200000	1.23
.40	400000	2.46
.20	800000	4.91
.10	1475000	9.06

Times interest earned ratio of less than 2.5% is considered as risky

The probability of not covering the interest payment at 35% debt level is 20%