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 25% 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 8%. 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? I. Increasing the financial leverage by adding debt has no effect on the firm's value. II. Increasing the financial leverage by adding debt results in an increase in 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? Do not round intermediate calculations. Round your answer to the nearest cent. $ per share What happens to the firm's earnings per share after the recapitalization? Do not round intermediate calculations. Round your answer to the nearest cent. The firm its EPS by $ . 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 0.20 750,000 0.10 1,200,000 Determine the times-interest-earned ratio for each probability. Do not round intermediate calculations. 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? Do not round intermediate calculations. Round your answer to two decimal places. %

Answer 1

I. Increasing the financial leverage by adding debt has no effect on the firm's value.

The stock price of Rivoli should not change. Stock Price = $15

EPS = (EBIT - Interest)*(1-Tax)/No. of Shares outstanding

Interest = 0.08*0.25*3000000 = 60000

No, of Shares outstanding = 0.75*3000000/15 = 150000

EPS = (500000-60000)*(1-0.4) /150000 = 1.76

Probability EBIT 0.10 - $ 100,000 0.20 200,000 0.40 500,000 0.20 750,000 0.10 1,200,000

Interest Times Earned Ratio = EBIT/Interest

0.1 ===> -100/60 = -1.67

0.2 ===> 200/60 = 3.33

0.1 ===> 750/60 = 12.50

0.1 ===> 1200/60 = 20.00

At 25% debt level, probability of not covering interest = 0.10