HiLo, Inc., doesn’t face any taxes and has $57.4 million in assets, currently fi
ID: 2742266 • Letter: H
Question
HiLo, Inc., doesn’t face any taxes and has $57.4 million in assets, currently financed entirely with equity. Equity is worth $5 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 9 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.)
HiLo, Inc., doesn’t face any taxes and has $57.4 million in assets, currently financed entirely with equity. Equity is worth $5 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
In the new capital structure, firm is switching to 25% debt capital structure. Hence the Equity would be 75% and debt would be 25%
New Equity = 75%*$574,000,000= $43,050,000
New Debt = 25%*$574,000,000= $14,350,000
Interest expense for the firm under new capital structure is 9% of the debt portion
Interest = 9%*14,350,000 = 1,291,500
Number of shares outstanding in the new capital structure =$43,050,000/$5
Number of shares = 8,610,000
Net income of the firm = EBIT – Interest Expense
State
Pessimistic
Optimistic
Expected EBIT
1,808,100
15,928,500
Debt Amount
14350000
14350000
Interest Rate
9%
9%
Interest Expense
1291500
1291500
Net Income
516,600
14,637,000
EPS = Net Income / Number of shares outstanding
EPS Pessimistic = $516,000 / 8,610,000 = $0.06
EPS Optimistic = $14,637,000 / 8,610,000 = $1.70
Expected value of EPS = Weighted average of EPS for both scenario
Expected value = 0.45 *0.06 + 0.55 * 1.70 = 0.962
State
Probability
EPS
Deviation from expected value
Squared deviation
Pessimistic
0.45
0.06
-0.902
0.813604
Optimistic
0.55
1.7
0.738
0.544644
Variance is weighted average of squared deviation
Variance = 0.45 * (0.813604) + 0.55 * (0.544644) = 0.665676
Standard Deviation = Squared root of Variance = SQRT(0.665676) = 0.82
State
Pessimistic
Optimistic
Expected EBIT
1,808,100
15,928,500
Debt Amount
14350000
14350000
Interest Rate
9%
9%
Interest Expense
1291500
1291500
Net Income
516,600
14,637,000
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.