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
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 Rivolis stock?
c) What happens to the firms earnings per share after the recapitalization?
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