Problem: The Rivoli Company has no outstanding debt and its financial position is given with the following data:
Assets (book=market) $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 percent debt based on market values, its cost of equity, rs, will increase to 11 percent to reflect the increased risk. Bonds can be sold at a cost, rd, of 7 percent. Rivoli is a no-growth firm. Hence, all its earnings are paid out as dividends, and earnings are exceptionally constant over time.
a. What would be the stock price of Rivoli's stock?
b. What happens to the firm's earnings per share after the recapitalization?
c. The $500,000 EBIT given previously is actually the expected value from the following probability distribution:
Probability EBIT
0.10 ($100,000)
0.20 200,000
0.40 500,000
0.20 800,000
0.10 1,100,000
Determine the times-interest earned ratio for each probability. What is the probability of not covering the interest payment at the 30 percent debt level?