Question

HiLo, Inc., doesn’t face any taxes and has $68.8 million in assets, currently financed entirely with equity. Equity is worth $6 per share, and book value of equity is equal to market value of equity. Also, let’s assume that the firm’s expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below:

State	Pessimistic				Optimistic
Probability of state		0.40				0.60
Expected EBIT in state	$	2,494,000			$	16,598,000

The firm is considering switching to a 25-percent-debt capital structure, and has determined that it would have to pay a 12 percent yield on perpetual debt in either event. What will be the standard deviation in EPS if the firm switches to the proposed capital structure? (Do not round intermediate calculations and round your final answer to 2 decimal places.)

Standard deviation in EPS

$

Answer 1

With 25% debt, debt = 68.8 x 25% = $17,200,000,

After debt, new outstanding shares = (68.8 - 17.2) / 6 = 8,600,000 shares

Interest Expense = 17,200,000 x 12% = 2,064,000

Net Income = EBIT - Interest expense

EPS = Net Income / Shares

Probability	EBIT	Net Income	EPS
0.4	2,494,000	430,000	0.05
0.6	16,598,000	14,534,000	1.69
		Mean	1.034

Mean Returns (M) = 0.4 x 0.05 + 0.6 x 1.69 = 1.034

Standard Deviation = [0.4 x (0.05 - 1.034^2 + 0.6 x (1.69 - 1.034)^2]^(1/2) = 80.34%