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Capital Structure Analysis & Swaps

Problem 1

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

Assets (book = market) $3,000,000
EBIT 500,000
Cost of equity rs 10%
Stock price P0 $15
Shares outstanding, n0 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 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 7%. Rivoli is a no-growth firm. Hence, all its earnings ate paid out as dividends, and earnings are expectationally constant over time.
a- What effect would this use of leverage have on the value of the firm?
b- What would be the price of Rivoli's stock?
c- What happens to the firm's earnings per share after the recapitalization?
d- The $500,000 EBIT given previously is actually the expected value from the following probability distribution:

Probability EBIT

0.10 ($100,000)
0.20 200,000
0.40 500,000
0.20 800,000
0.10 1,100,000

Determine the times interest earned ratio for each probability. What is the probability of not covering the interest payment at the 30% debt level?

Problem 2

Carter Enterprises can issue floating rate debt al LIBOR + 2% or fixed rate debt at 10.00%. Brence Manufacturing can issue floating rate debt at LIBOR = 3.1% or fixed rate debt at 11%. Suppose Carter issues floating rate debt and Brence issues fixed rate debt. They are considering a swap in which
Carter will make a fixed rate payment of 7.95% to Brence, and Brence will make a payment of LIBOR to Carter. What are the net payments of Carter and Brence if they engage in the swap? Will Carter be better off to issue fixed rate debt of to issue floating rate debt and engage in the swap? Will Brence be better off to issue floating rate debt or to issue fixed rate debt and engage in the swap?

Solution Preview

Problem 16-9ius (Capital; Structure analysis ) 

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

Assets (book = market)                                  $3,000,000 
EBIT                                                       500,000 
Cost of equity rs                                            10% 
Stock price P0                                               $15 
Shares outstanding, n0                                     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 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 7%.  Rivoli is a no-growth firm.  Hence, all its earnings ate paid out as dividends, and earnings are expectationally constant over time.  

a- What effect would this use of leverage  have on the value of the firm?

Original value of the firm (D ...

Solution Summary

Detailed analysis of questions including relevant formula.

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