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, r,................................... 10%
Stock price, Po .................................... $ 15
Shares outstanding, no ........................... 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 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, and 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 market value of Rivoli's equity?
c. 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 converting the interest payment at the 30% debt level?