HiLo, Inc., doesn’t face any taxes and has $68.8 million in assets, currently fi

Question

HiLo, Inc., doesn’t face any taxes and has $68.8 million in assets, currently financed entirely with equity. Equity is worth $6 per share, and book value of equity is equal to market value of equity. Also, let’s assume that the firm’s expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below:

The firm is considering switching to a 25-percent-debt capital structure, and has determined that it would have to pay a 12 percent yield on perpetual debt in either event. What will be the standard deviation in EPS if the firm switches to the proposed capital structure? (Do not round intermediate calculations and round your final answer to 2 decimal places.)

Standard Deviation in EPS $_____________

HiLo, Inc., doesn’t face any taxes and has $68.8 million in assets, currently financed entirely with equity. Equity is worth $6 per share, and book value of equity is equal to market value of equity. Also, let’s assume that the firm’s expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below:

Explanation / Answer

Interest in all states will be equal to 0.12 × (0.25 × $68,800,000) = $2,064,000, and

the number of shares outstanding will be equal to (0.75 × $68,800,000)/$6 = 8,600,000

The EPS in each state of nature will be as shown:

EPS WITH 40% DEBT

The expected EPS will be equal to (0.40 × $0.05) + (0.60 ×$1.69) = $1.034, so the standard deviation in EPS will be equal to:

?EPS = [0.40(0.05 - 1.034)2 + 0.60(1.69 - 1.034)2]1/2

= $0.8034

STATE PESSIMISTIC OPTIMISTIC EBIT $2,494,000 $16,598,000 - Interest 2,064,000 2,064,000 EBT $ 430,000 $14,534,000 - Taxes(@0%) 0 0 Net Income $ 430,000 $14,534,000 EPS $ 0.05 $ 1.69

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