Question

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 35% debt based on market values, its cost of equity, r_s, will increase to 11% to reflect the increased risk. Bonds can be sold at a cost, r_d, of 9%. 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 would be the price of Rivoli's stock? Do not round intermediate calculations. Round your answer to the nearest cent.

B) What happens to the firm's earnings per share after the recapitalization? Do not round intermediate calculations. Round your answer to the nearest cent.

C) The $500,000 EBIT given previously is actually the expected value from the following probability distribution:

Probability	EBIT
0.10	- $ 110,000
0.20	250,000
0.40	500,000
0.20	750,000
0.10	1,110,000

Determine the times-interest-earned ratio for each probability. Do not round intermediate calculations. Round your answers to two decimal places.

D)What is the probability of not covering the interest payment at the 35 percent debt level? Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

Solution:

The Rivoli Company’s current capital structure is debt free.

Earning before interest tax (EBIT) = Rs. 5.0 million

Tax rate = 40%

Net income = 5 * (1-40%) = 3.0 million

Earning per share (EPS) = Net income/share outstanding

EPS = 3/2 = 1.5

P/E ratio = Market value per share/EPS

= 15/1.5 = 10

Post introduction of debt, net income will be as follows:

Net income = 5*(1-40%) * (1-9%) = 2.73

Here, 9% is cost of bond or coupon rate

Now:

EPS = 2.73/2 = 1.37

Hence,

Market value per share = 10*1.37 = 13.65

P/E ratio was 10 as calculated above.

Hence, price of stock would reduce from $15 to $13.65

And EPS would reduce from 1.5 to 1.37.