The Rivoli Company has no debt outstanding and its financial position is given b
ID: 2800122 • Letter: T
Question
The Rivoli Company has no debt outstanding and its financial position is given by the following data:
Assets (book = market)
$3,000,000
EBIT
$ 500,000
Cost of equity, rs
10%
Stock price, P0
$15
Shares outstanding, n0
200,000
Tax rate, T
40%
The firm is considering selling bonds and simultaneously repurchasing some of its stock. If it moves to a capital structure with 40% 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 7%. 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?
b) What would be the price of Rivoli’s stock?
c) What happens to the firm’s earnings per share after the recapitalization?
Assets (book = market)
$3,000,000
EBIT
$ 500,000
Cost of equity, rs
10%
Stock price, P0
$15
Shares outstanding, n0
200,000
Tax rate, T
40%
Explanation / Answer
Answer:
1. All figures in USD
S.No. Parameters Current Year Next Year 1 EBIT 500,000 500,000 2. Interest 0 94,595 3 Taxes@40% 200,000 162,162 4. PAT 300,000 243,243 5 EPS 1.50 1.22 6. No. of Shares Outstanding 200,000 200,000 7 Cost of Debt 0% 7% 8 Cost of Equity 10% 12% 9 Debt 0% 40% 10. Equity 100% 60% 11 WACC=((Equity/Value of Firm)*Cost of Equity+(debt/Value of Firm)*Cost of Debt*(1-Tax Rate)) 10% 8.88% 12 Value of Firm = EBIT*(1-Tax Rate)/WACC 3,000,000 3,378,378 13 Debt 0 1,351,351 14 Equity 3,000,000 2,027,027 15 Stock Price 15 10.14Related Questions
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