$16-8$ Capital Structure Analysis

The Rivoli Company has no debt outstanding, and its financial position is

given by the following data:

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 val$-$

ues, its cost of equity, $r_s,$ will increase to $11\%$ to reflect the increased risk. Bonds

can be sold at a cost, $r_d,$ of $7\%.$ Rivoli is a no$-$growth firm. Hence, all its earn$-$

ings 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:

Determine the times$-$interest$-$earned ratio for each probability. What is the

probability of not covering the interest payment at the $30\%$ debt level?