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Capital Structure: Repurchase of stock

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

Assets (book = market) $5,000,000
EBIT $750,000
Cost of equity, rs 10%
Stock price, P0 $10
Shares outstanding, n0 500,000
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 30% 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 6%. Tivoli is a no-growth firm. Hence, all its earnings are paid out as dividends, and earnings are expectationally constant over time.

What would the value of the firm be after this debt-for-stock restructuring of the firm is completed?
What would be the price of Tivoli's stock after this debt-for-stock restructuring of the firm is completed?
What will be the firm's earnings per share after this debt-for-stock restructuring of the firm is completed?

Solution Summary

Calculates the value of the firm, price of stock and earnings per share after debt-for-stock restructuring of the firm is completed.

$2.19