Problem: The Rivoli Company has no debt outstanding, and its financial position is given by the following data:
Assets (book= market) $3,000,000
EBIT $500,000
Cost of equity, rs 10%
Stock Price, P0 $15
Shares Outstanding, n0 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 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.
Q1. What effect would this use of leverage have on the value of the firm?