Question

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 8%. 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 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  

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

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 $   .

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

Probability	EBIT
0.10	($ 80,000)
0.20	250,000
0.40	350,000
0.20	850,000
0.10	1,480,000

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 35% debt level? Do not round intermediate calculations. Round your answer to two decimal places.

  %

Answer 1

Answer 1:

Correct answer is:

I. Increasing the financial leverage by adding debt results in an increase in the firm's value.

Explanation:

WACC = Cost of equity * Equity % + Cost of debt * (1 - Tax rate) * Debt %

WACC before capitalization (when debt = 0%) = 10% * 100% + 0 = 10%

WACC after capitalization (when debt = 35%) = 12% * (1 - 35%) + 8% * (1 - 40%) * 35% = 9.48%

Given:

Rivoli is a no-growth firm:

Free Cash Flow (FCF) after recapitalization = EBIT * (1 - tax rate) = 500000 * (1 - 40%) = $300,000

Value of the firm after recapitalization = FCF / WACC = 300000 / 9.48% = $3,164,556.96

As such we find that increasing the financial leverage by adding debt to have 35% debt results in an increase in the firm's value from $3,000,000 to $3,164,556.96.

As such option I is correct and other options II and III are incorrect.

Answer 2:

Value of firm = $3,164,556.96

Equity = $3,164,556.96 * (1 -35%) = $2,056,962.03

Debt = $3,164,556.96 * 35% = $1,107,594.94

Share price = (equity value + (debt after recapitalization + Debt before recapitalization)) / Number of shares before recapitalization

= (2056962.03 + (1107594.94 - 0)) / 200000 = $15.82278

Share price = $15.82 per share

Answer 3:

Number of shares repurchased = 1107594.94 / 15.82278 = 70,000

Number of shares outstanding after recapitalization = 200000 - 70000 = 130,000

EPS before recapitalization = (EBIT - Interest) * (1 - Tax rate) / Number of shares = 300000 / 200000 = $1.50

EPS after recapitalization = (500000 - 1107594.94 * 8%)* (1 - 40%) / 130000 = $1.90

As such EPS increases by (1.90 - 1.50 =) $0.40 per share

The firm increased its EPS by $0.40

Answer 4:

Workings:

Interest = 1107594.94 * 8% = $88,607.59

Answer 5:

From above table (in workings to answer 4) we observe only in case 10% probability TIE is negative and for all other cases TIE is greater than one.

Hence:

Probability of not covering the interest payment at the 35% debt level = 10%