--%>
Assignment Help - homework help

Problem on raising new capital

AB Corporation has 3 million shares of common stock selling at $19 each. It also contains $25 million in bonds with coupon rate of 8%, selling at par. AB requires $10 million in new capital that it can raise by selling stock at $18, or bonds at 9% interest. The expected EBIT subsequent to the new capitalization is $6 million, with a standard deviation of $3 million. Determine the preferred method of raising new capital? What is the probability that you are correct?

E

Expert

Verified

From the given details,

When the issue of shares is involved, to raise $10 million at $18/share, the outstanding shares will increase by 0.56 million.

As a result, the earnings available to common shareholders are higher under common stock alternative than they are under the debt alternative. Hence the financing method must be to raise $10 million by selling shares at $18 per share.

In order to determine the probability that this decision is right, we need the indifference point between the two alternatives.

((EBIT - $2900)(1 – 0.4) – 0)/3000 = ((EBIT - $2000)(1 – 0.4) – 0)/3555.56
3555.56*(0.6 EBIT – 1740) = 3000*(0.6 EBIT – 1200)
2133.33 EBIT – 6,186,667 = 1800 EBIT – 3,600,000
333.333 EBIT = 2,586,667
EBIT = $7,760 (in thousands)

Hence the probability that the above decision is right is

Z = ($7760 – 6000)/3000 = 0.5867
P(z) = 72.13%

Thus the equity financing must be recommended and the probability that this is right is 72.13%.

   Related Questions in Corporate Finance

  • Q : Compute a company's cost of capital in

    How can we compute a company's cost of capital in emerging nations, particularly when there is no state bond that we could take as a reference?

    		•
  • Q : DCF Analysis AB Corp. is in the

    AB Corp. is in the business of making white-board markers. They are computing the potential of investing in some new equipment that will enhance their manufacturing process.  The initial cost of the latest machinery is $470,000 plus a one-time installation cost o

    		•
  • Q : Affect the value of the stock Is the

     Is the value of this stock dependent on how long you plan to hold it? In other words, if your planned holding period were 2 years or 5 years rather than 3 years, would this affect the value of the stock today, P0? Explain your answer.<

    		•
  • Q : Standard deviation of portfolios returns

    Assume that you have $50,000 which you want to invest in two companies, XYZ Books and ABC Audio. XYZ has a return of 10% and standard deviation 15%, while ABC has return of 15% with a standard deviation of 20%. The correlation coefficient between them is .5. Your port

    		•
  • Q : Is net income of a year is doubtful for

    Is the net income of a year money the company made that given year or is this a number whose importance is quite doubtful?

    		•
  • Q : Is there any optimal capital structure

    Is there any optimal capital structure?

    		•
  • Q : Explain Straddle and Strangle Straddle

    Straddle & Strangle: In the case of shorting butterfly spread, it can be seen that the gains are limited. However, there exists another strategy known as straddle which produces unlimited gains. This strategy benefits when the trader expects that

    		•
  • Q : How economic doctrine relies on

    I read in a sentence passed through the Supreme Court that, so as to value companies, economic doctrine relies upon intermediary methods among ‘Anglo-Saxon’ theoretical models and the practical models common in the United

    		•
  • Q : Variance of a portfolio The variance of

    The variance of a portfolio of 40 stocks will be the addition of _______ variance terms and _______ covariance terms. A) 40; 1560B) 40; 1600C) 80; 40D) 1600; 40

    		•
  • Q : Who introduced put–call parity Who

    Who introduced put–call parity?

    		•