The Rivoli Company has no debt outstanding, and its financial position is given
ID: 2792447 • Letter: T
Question
The Rivoli Company has no debt outstanding, and its financial position is given by the following data Asset (book market) EBIT Cost of equity, Stock price, P Shares outstanding, no Tax rate, T (federal +state) $3,000,000 500,000 10% $15 200,000 40% The firm is considering bonds and simultaneously repurchasing some of its stock. If it moves to capital structure with 30% debt based on market values, its cost of equity, will increase to 11 % to reflect the increased risk. Bonds can be sold at a cost (d) of 7%. Rivoli is a no growth firm. Hence, all its earnings are paid out as dividends, and earnings are expected constant over time (8 pts) 1. What effect would this use of leverage have on the value of the firm? Calculate the value of the firm with new capital structure. (hint: first calculate WACC, then...get value of firm). What would be the price of Rivoli's stock? 3. What is the firm's eamings per share before and after the recapitalization?Explanation / Answer
1) WACC = we x ke + wd x kd x (1 - tax)
Here, we - weight of equity = 70%, ke - cost of equity = 11%, wd - weight of debt = 30%, kd - cost of debt = 7%,
=> WACC = 70% x 11% + 30% x 7% x (1 - 40%) = 8.96%
Value of firm = EBIT x (1 - tax) / WACC = 500,000 x (1 - 40%) / 8.96% = $3,348,214
2) Debt = 3,000,000 x 30% = $900,000
No. of shares repurchased = 900,000 / 15 = 60,000 shares
New outstanding shares = 200,000 - 60,000 = 140,000 shares
Value of equity = (Firm Value - Debt) / No. of shares = (3,348,214 - 900,000) / 140,000 = $17.49
3) Before recap, EPS = EBIT x (1 - tax) / No. of shares = 500,000 x (1 - 40%) / 200,000 = $1.50
After recap, EPS = (EBIT - Interest) x (1 - tax) / No. of shares = (500,000 - 900,000 x 7%) x (1 - 40%) / 140,000
= $1.87
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