Leverage Analysis
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16-3
The Rivoli Comapny has no debt outstanding, and its financial position is given by the following data:
Assets (book = market) $3,000,000
EBIT $5000,000
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 capital structure with 30% debt based on market values, its cost of equity, rs, will increase to 11% tp reflect the increased risk. Bonds can be sold at a cost, rd, of 7%. Rivoli is a no-growth firm. hence, all its earning are 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 firms earnings per share after the recapitalization?
d. The $500,000 EBIT given previously is actually the expected value form the following probability distribution:
Probabilty EBIT
____________________________________
0.10 ($ 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?
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Solution Summary
The solution calculates the effect of leverage (due to repurchase of stocks with the money raised by selling bonds) on the value of the firm, the price of Rivoli's stock, the effect of recapitalization on the firm's earnings per share and calculates the times-interest earned ratio.
Solution Preview
The Rivoli Comapny has no debt outstanding, and its financial position is given by the following data:
Assets (book = market) $3,000,000
EBIT $5000,000
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 capital structure with 30% debt based on market values, its cost of equity, rs, will increase to 11% tp reflect the increased risk. Bonds can be sold at a cost, rd, of 7%. Rivoli is a no-growth firm. hence, all its earning are paid out as dividends, and earnings are expectationally constant over ...
Purchase this Solution
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