Capital Structure Analysis

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 30% debt based on market values, its cost of equity, rs, will increase to 12% 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.

a. What effect would this use of leverage have on the value of the firm?

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.

b. What would be the price of Rivoli’s stock? Round your answer to the nearest cent, e.g. $per share

c. What happens to the firm’s earnings per share after the recapitalization? Round your answer to the nearest cent.

EPS by $

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

Probability EBIT

0.10 – $ 90,000

0.20 200,000

0.40 450,000

0.20 800,000

0.10 1,290,000

Determine the times-interest-earned ratio for each probability. Round your answers to two decimal places.

Probability TIE

0.1

0.2

0.4

0.2

0.1

What is the probability of not covering the interest payment at the 30 percent debt level? Round your answer to two decimal places.

%.