Capital Structure Analysis
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 40% debt based on market values, its cost of equity, rs, will increase to 13% to reflect the increased risk. Bonds can be sold at a cost, rd, of 6%. Rivoli is a no-growth firm. Hence, all its earnings are paid out as dividends. Earnings are expected to be constant over time. Do not round intermediate calculations, except, number of shares which should be rounded to nearest whole number.
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.
What would be the price of Rivoli's stock? Round your answer to the nearest cent.
$ ______ per share
What happens to the firm's earnings per share after the recapitalization? Round your answer to the nearest cent.
The firm _________ its by EPS by $_______
increased
decreased
The $500,000 EBIT given previously is actually the expected value from the following probability distribution:
Probability EBIT
0.10 -$
$ 120,000
0.20 150,000
0.40 400,000
0.20 850,000
0.10 1,520,000
Determine the times-interest-earned ratio for each probability. Round your answers to two decimal places. Enter negative answers with a minus sign.
Probability TIE
0.10 _______
0.20 _______
0.40 _______
0.20 _______
0.10 _______
What is the probability of not covering the interest payment at the 40% debt level? Round your answer to two decimal places.
_____%.