Problem 15-8 Capital Structure Analysis The Rivoli Company has no debt outstandi
ID: 2382805 • Letter: P
Question
Problem 15-8
Capital Structure Analysis
The Rivoli Company has no debt outstanding, and its financial position is given by the following data:
The firm is considering selling bonds and simultaneously repurchasing some of its stock. If it moves to a capital structure with 25% debt based on market values, its cost of equity, rs, will increase to 13% to reflect the increased risk. Bonds can be sold at a cost, rd, of 6%. Rivoli is a no-growth firm. Hence, all its earnings are paid out as dividends. Earnings are expected to be constant over time.
What effect would this use of leverage have on the value of the firm?
-Select-IIIIIIItem 1
I. Increasing the financial leverage by adding debt results in an increase in the firm's value.
II. Increasing the financial leverage by adding debt has no effect on the firm's value.
III. Increasing the financial leverage by adding debt results in a decrease in the firm's value.
What would be the price of Rivoli's stock? Round your answer to the nearest cent.
$ per share
What happens to the firm's earnings per share after the recapitalization? Round your answer to the nearest cent.
The firm -Select-increaseddecreasedItem 3 its EPS by $ .
Problem 15-8
Capital Structure Analysis
The Rivoli Company has no debt outstanding, and its financial position is given by the following data:
Assets (Market value = book value) $3,000,000 EBIT $500,000 Cost of equity, rs 10% Stock price, Po $15 Shares outstanding, no 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 25% debt based on market values, its cost of equity, rs, will increase to 13% to reflect the increased risk. Bonds can be sold at a cost, rd, of 6%. Rivoli is a no-growth firm. Hence, all its earnings are paid out as dividends. Earnings are expected to be constant over time.
What effect would this use of leverage have on the value of the firm?
-Select-IIIIIIItem 1
I. Increasing the financial leverage by adding debt results in an increase in the firm's value.
II. Increasing the financial leverage by adding debt has no effect on the firm's value.
III. Increasing the financial leverage by adding debt results in a decrease in the firm's value.
What would be the price of Rivoli's stock? Round your answer to the nearest cent.
$ per share
What happens to the firm's earnings per share after the recapitalization? Round your answer to the nearest cent.
The firm -Select-increaseddecreasedItem 3 its EPS by $ .
Determine the times-interest-earned ratio for each probability. Round your answers to two decimal places. Probability TIE 0.10 0.20 0.40 0.20 0.10
What is the probability of not covering the interest payment at the 25 percent debt level? Round your answer to two decimal places.
%.
Explanation / Answer
1. Firm's financial leverage will increase since the debt is getting add in the capital structure which will increase the financial risk and as a result financial leverage will increase.
2. P = D/(rs-g) but since the growth is zero the the formula will be, P = D/rs where D = Dividend, P = price and rs = Cost of equity
Number of shares re-purchase = (3,000,000 x 25%) / 15 = 50,000 shares
Interest = 3,000,000 x 25% x 6% = $45,000
New Dividend = [(500,000 - 45,000) x (1 - 0.40)] / (200,000 - 50,000) = $1.82 per share
P = 1.82 / 13% = $14
3. The firm's EPS(which is equal to DPS) will increase from $1.50 to $1.82. This is due to Trading on Equity which means increasing the shareholders's wealth by icreasing the debt component in the capital structure.
4.
5. 10 % is the probability of not covering the interest payment at the 25 percent debt level since there is 10% chances of negative EBIT.
Probability TIE 0.10 NA 0.20 3.33 0.40 8.89 0.20 21.11 0.10 29.22