1.River Cruises is all-equity-financed with 100,000 shares.It now proposes to issue $350,000 of debt at an interest of 10% and use the proceeds to repurchase 35,000 shares.Profits before interest are expected to be $175,000.The tax rate of the company is 40%.

a.What is the ratio of price to expected earnings for River Cruises before the debt issue and stock repurchase?

b.What is the ratio of PE after the debt issue and stock repurchase?

c.Analyze the difference you find between a) and b)

d.How would you change your assessment in b if you assume the market inputs the value of tax shields in the stock price?

2.Reliable Gearing currently is all -equity-financed.It has 10,000 shares of equity outstanding, selling at $12 a share.The firm is considering a capital restructuring.The low-debt plan calls for a debt issue of $300,000 with the proceeds used to buy back stock.The high-debt plan would exchange $450,000 of debt for equity.The debt will pay an interest rate of 10%.EBIT is is $130,000.

a.What will be the debt/equity ratio (book value) for each case?

b.What would be the EPS in each case if the company pays no taxes?

c.What would the EPS in each case if the company pays 50% of taxes?

d.What plan would you recommend the company to implement?Assess all pros and cons

3.Assume the cost of capital of Reliable Gearing is 10% when it has zero debt.

a.What would be the cost of capital after the debt issue in each case? Assuming the company pays a 50% tax rate

b.What was ROE before the debt issue and after the high-debt plan issue?Use Dupont analysis

c.Could you assess if the company created value by following the high-debt plan?