Problem:
Rivoli Company has no debt outstanding, financials are:
Assets (book = market) $3,000,000
EBIT $500,000
Cost of equity 10%
Stock price $15
shares outstanding 200,000
Tax rate 40%
Firm 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 will increase to 11% to reflect risk. Bonds could be sold at cost of 7%, no growth firm, all earnings paid as dividends. Earnings expected to be constant over time.
a) What effect would this use of leverage have on value of firm?
b) What would be price of Stock?
c) What happens to firms earnings per share after recapitalization?
d) $500,000 EBIT given previously is actually expected value from following probability distribution:
Probability EBIT
.10 ($100,000)
.20 200,000
.40 500,000
.20 800,000
.10 1,100,000
Determine the times-interest-earned ratio for each probability. What is the probability of not covering interest payment at 30% debt value?