Capital Structure Analysis The Rivoli Company has no debt outstanding, and its f
ID: 2779190 • Letter: C
Question
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 35% 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 7%. 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 results in a decrease in the firm's value.
III. Increasing the financial leverage by adding debt has no effect on 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 $ .
The $500,000 EBIT given previously is actually the expected value from the following probability distribution:
Determine the times-interest-earned ratio for each probability. Round your answers to two decimal places.
What is the probability of not covering the interest payment at the 35 percent debt level? Round your answer to two decimal places.
%.
Explanation / Answer
1. Option III
Increasing the financial leverage by adding debt has no effect on the firm's value. This is because, you buy back bonds to issue debts.
2.
3. Earnings per share before restructuring : 500,000 *(I-Tax rate)/200,000 = 500,000*0.6 / 200,000 = 1.5
Earning after restructuring: (500,000 - Interest paid) *(1-Tax rate) / Outstanding shares
= (500,000 - 0.07*Debt value)*0.6 / 130,000
= (500,000 - 73,500)*0.6 / 130,000
= 1.96
Hence eraning per share increases .This is because, cost of debt is lower than cost of equity.
market value = 3,000,000 35 % Debt value = 1,050,000 Equity 1,950,000 No of shares bought back = Debt/ Market value of share = 70,000 Outstanding shares = Initial shares - shares bought back 130,000 Share price after repurchase = Market value of equity / outstanding shares 15 Hence there is no change in share price