Please help me solve this, answers are below: The Rivoli Company has no debt out

ID: 2731389 • Letter: P

Question

Please help me solve this, answers are below:

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, 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 are paid out as dividends. Earnings are

expected to be 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?

a. V = $3,348,214.

b. $16.74.

c. $1.84.

d. 10%.

(1) Debt = 30% P0 = D1/Ke 368303/11% =3348214

(2)3348214/200000=16.74

(3) 262200/140000=1.87

(4) 0.10 ($ 100,000)