The Rivoli Company has no debt outstanding, and its financial position is given

Question

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 11% to reflect the increased risk. Bonds can be sold at a cost, rd, of 8%. Rivoli is a no-growth firm. Hence, all its earnings are paid out as dividends. Earnings are expected to be constant over time.

a.What would be the price of Rivoli's stock? Round your answer to the nearest cent.

b. What happens to the firm's earnings per share after the recapitalization? Round your answer to the nearest cent. The Firm increased its EPS by how much?? Round to nearest cent.

Explanation / Answer

a.Total assets = 3,000,000

Amount of debt to be raised = 40% of 3,000,000 = 1,200,000

So total number of shares to be repurhased = 1,200,000/15 = 80,000

So total number of shares left = 200,000 - 80,000 = 120,000

Now EBIT = 500,000

Interest of 8% on 1,200,000 = 96,000

EBT = 500000-96000 = 404,000

Hence Net Income = 404,000*(1-0.4) = 242,400

Dividends = 242,400/120,000 = $2.02/share

Now the share price = Dividend/ Rate of return

Rate of return = 0.4 * 8*(1-0.4) + 0.6 * 11 = 8.52%

Hence new stock price = 2.02/0.0852 = $23.71

b. The earnings per share (EPS) now = $2.02/share

Old EPS = 500000*(1-04)/200,000 = $1.5/share

Hence EPS icnreased by 2.02-1.5 = $0.52/share

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