Capital Structure Analysis The Rivoli Company has no debt outstanding, and its f

Question

Capital Structure Analysis

The Rivoli Company has no debt outstanding, and its financial position is given by the following data:

The firm is considering selling bonds and simultaneously repurchasing some of its stock. If it moves to a capital structure with 25% 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 7%. 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?
-Select-IIIIIIItem 1
I. Decreasing the financial leverage by adding debt has no effect on the firm's value.
II. Decreasing the financial leverage by adding debt results in a decrease in the firm's value.
III. Decreasing the financial leverage by adding debt results in an increase in 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 -Select-increaseddecreasedItem 3 its EPS by $___________ .

The $500,000 EBIT given previously is actually the expected value from the following probability distribution:

Determine the times-interest-earned ratio for each probability. Round your answers to two decimal places. Enter negative answers with a minus sign.

______

What is the probability of not covering the interest payment at the 25% debt level? Round your answer to two decimal places.

_________%.

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%

Explanation / Answer

1)

Decreasing the financial leverage by adding debt results in an increase in the firm's value (Option 3)

EBIT = 500000

Debt = 3000000*(25%/(1-25%)) = 1000000

Interest = 7%*1000000 = 70000

EBT = 500000 - 70000 = 430000

PAT = (1-40%)*430000 = 258000

Dividend = 258000 / 200000 = 1.29 (EPS is also same)

2)

Stock price = 1.29 / 13% = 9.92

3)

Decrease in EPS = (500000*(1-40%) - 258000 ) / 200000 = 0.21

4)

At Probability of 0.1 = -105000 / 70000 = -1.5

At Probability of 0.2 = 250000 / 70000 = 3.57

At Probability of 0.4 = 400000 / 70000 = 5.71

At Probability of 0.2 = 900000 / 70000 = 12.86

At Probability of 0.1 = 1205000 / 70000 = 17.21

5)

According to 4th answer, Probability = 0.1 (As interest coverage is less than 1)

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