Question

S b 12-10 Capital Shure Analyst . Discuss the relative riskiness of the three firms returns. Assume that these distributions are expected to remain constant over time! Now suppose that all three firms have the same standard deviation of basic earning power (EBIT/Total assets), 55. What can we tell about the financial nisk of each firm? Fikse Gardening Supplies has no debt outstanding and its financial position is given by the following data: Assets Ibookmarket) 1,000,000 ET $500,000 Cost of equity : Stock price, Share outstanding, 520000 Tax rate, 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. Ty will increase to 9.5 to reflect the increased risk Bonds can be sold at a cost of 7 . Fikse is a nd-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 Fikse's equity? C. The $500,000 EBIT given previously is actually the expected value from the following probabtlity distribution: Probability EBIT 0.10 SC100,000 0.20 200,000 500,000 0.200 800,000 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?

Answer 1

a). Current value of the firm = asset value = 4,000,000

New WACC after taking on debt is (weight of debt*cost of debt*(1-Tax rate)) + (weight of equity*cost of equity)

= (0.30*7%*(1-30%)) + (0.70*9.5%) = 8.12%

New firm value = EBIT*(1-Tax rate)/WACC (as it is a no-growth firm)

= 500,000*(1-30%)/8.12% = 4,310,344.83

Thus, adding leverage will increase firm value from 4,000,000 to 4,310,344.83.

b). Current capital structure has 30% debt and 70% equity so market value of equity is

70%*firm value = 70%*4,310,344.83 = 3,017,241.38

c). Times Interest earned = EBIT/interest expense

Interest expense = debt amount*interest rate = (30%*4,310,344.83)*7% = 90,517.24

Probability	EBIT	Interest	Times interest earned
0.1	-100000	90517.24	-1.10
0.2	200000	90517.24	2.21
0.4	500000	90517.24	5.52
0.2	800000	90517.24	8.84
0.1	1100000	90517.24	12.15

Interest payment won't be covered when EBIT is negative so the probability that interest payment is not covered is 0.1 or 10%.