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The Rivoli Company has no debt outstanding, and its financial position is given by the following...

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, P0 $ 15, Shares outstanding, n0 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 11% 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?

d. 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/ 800,000, 0.10/ 1,100,000. Determine the times-interest-earned ratio for each probability. What is the probability of not covering the interest payment at the 30% debt level? a. V = $3,348,214. b. $16.74. c. $1.84. d. 10%.

Capital Structure:

Capital structure is define as combination of multiple instruments in company's capital ,these instruments can be long term bond, ordinary shares, preference shares, warrants etc. The cost of capital depend on the proportion and cost of each component in the capital structure. The cost of capital should be lower than the peer group in the industry.

Answer and Explanation:

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Answer a)

Original value of the firm (D = $0)

V = $3,000,000. (given)

Original cost of capital, calculated by use of

{eq}WACC = w_d*C_d*(1- Tax)...

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Capital Structure & the Cost of Capital

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Chapter 15 / Lesson 1
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In this lesson, we'll define capital and a firm's capital structure. We'll also discuss the costs associated with each component in the capital structure and learn about the concept of risk and return.


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