Assume that a company has $10 million in assets (where the market value of the assets is equal to the book value of the assets) and no debt. The company's marginal tax rate is 35% and has 500,000 shares outstanding. The company's earnings before interest and taxes (EBIT) is $3.88 million. The firm's stock price is $27 per share and the cost of equity is 11%.
The company is thinking of issuing bonds and simultaneously repurchasing a portion of its stock. If the company changes its capital structure from no debt to 25% debt based on market values, the firm's cost of equity will increase to 13% because of the increased risk. The bonds can be sold at a cost of 9%. The firm's earnings are not expected to grow over time. All of its earnings will be paid out as dividends.
Answer the following questions:
a.What impact will this utilization of this debt have on the value of the company?
b.What's going to be the company's EPS after the recapitalization?
c.What's going to be the company's new stock price?
d.The $3.88 million EBIT discussed above is determined from this probability distribution:
Probability EBIT ($)
0.05 - 1 million
0.25 2.3 million
0.4 4 million
0.25 5.8 million
0.05 6.1 million
What's the times interest earned ratio at each probability level?
Analyzing a Firm's Capital Structure