Question

HiLo, Inc., doesn’t face any taxes and has $56.8 million in assets, currently financed entirely with equity. Equity is worth $5 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 0.45 0.55 Expected EBIT in state $ 1,533,600 $ 14,910,000 The firm is considering switching to a 25-percent-debt capital structure, and has determined that it would have to pay a 9 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.)

Answer 1

Value of Assets = $56.8 million = $56,800,000

As per proposed capital structure debt will be 25%

So, Value of debt = 0.25*$56,800,000 = $14,200,000

Value of Equity = $56,800,000 - $14,200,000 = $42,600,000

No of shares outstanding = Value of Equity/Price per share = $42,600,000/$5 = 8,520,000

Interest applicable on either state = 9%*$14,200,000 = $1,278,000

EPS Calculations:

Formulas Used:

Expected EPS = Prob₁*EPS₁ + Prob₂*EPS₂ = 0.45*0.03 + 0.55*1.6 = $0.8935

Variance = 0.45*(0.03-0.8935)² + 0.55*(1.6-0.8935)² = 0.6101

Standard Deviation in EPS = square root of variance = sqrt(0.6101) = 0.78

Ans: Standard deviation in EPS = 0.78