--%>
Assignment Help - homework help

EPS problem

XY Corporation is an all equity firm with a total value of $20 million. It needs an additional capital of $5 million, which may be either equity, or debt at the interest rate of 10%. After the new capitalization, the expected EBIT is $5 million, with standard deviation of $1.5 million. The company pays income tax at 50% rate, and it has 1 million shares outstanding. What is the preferred technique of raising new capital, if the objective is to maximize the EPS? What is the probability that you are correct in your decision?

E

Expert

Verified

From the given details,

Total value of the firm is $20 million which has 1 million shares and hence the share price is $20/share. When the issue of shares is involved, to raise $5 million at $20/share, the outstanding shares will increase by 0.25 million.

854_95.22.jpg



As a result, the earnings available to common shareholders are higher under common stock alternative than they are under the debt alternative. Hence the financing method must be to raise $5 million by issuing debt at 10% interest rate.

In order to determine the probability that this decision is right, we need the indifference point between the two alternatives.

((EBIT - $0.5)(1 – 0.5) – 0)/1 = ((EBIT - $0)(1 – 0.5) – 0)/1.25
1.25*(0.5 EBIT – 0.25) = 1*(0.5 EBIT)
0.625 EBIT – 0.3125 = 0.5 EBIT
0.125 EBIT = 0.3125
EBIT = $2.5 million

Hence the probability that the above decision is right is

Z = ($2.5 – 5)/1.5 = -1.667
P(z) = 95.22%

Thus the debt financing must be recommended and the probability that this is right is 95.22%.

   Related Questions in Corporate Finance

  • Q : Problem on financial manager

    Assume that you are a financial manager of Yuen Cheong Manufacturng Company. Due to the rising demand of product X, Yuen Cheong Manufacturng Company decides to open a new production plant in China, so it needs to take a loan of US$1 million. Bank A offers Yuen Cheong

    		•
  • Q : Market for Corporate Bonds Write some

    Write some point regarding Market for Corporate Bonds.

    		•
  • Q : Explain the Monte Carlo evaluation of

    Explain the Monte Carlo evaluation of integrals.

    		•
  • Q : Option Trading Strategies Explain the

    Explain the term Option Trading Strategies?

    		•
  • Q : Define the term Commercial Paper

    Commercial Paper: It is an unsecured obligation issued by the corporation or bank to finance its short-term credit requirements, like accounts inventory and receivable. Maturities usually range from 2 to 270 days. The commercial paper is accessible in

    		•
  • Q : Calculate present value of expected

    When valuing the shares of my company, I calculate the present value of the expected cash flows to shareholders moreover I add to the result obtained cash holdings and liquid investment. Is that correct?

    		•
  • Q : What is Net Operating Profit after Tax

    What is Net Operating Profit after Tax (NOPAT)?

    		•
  • Q : Calculating Super normal profit The

    The case study of an economic analysis is done for Schlumberger, oilfield Service Company.  They are No. 1 in terms of market caps, revenue and employees globally. When any references are used/outside sources (except for Schlumberger's annual reports and financia

    		•
  • Q : Explain undervaluation of share on the

    Suppose we calculate g as ROE (1–p)/(1–ROE (1–p)) and the Ke by the CAPM. We replace both values into the formula PER = (ROE (1+g) – g)/ROE (Ke-g) but there PER we obtain is fully different from the one we get by dividing the quotation of the s

    		•
  • Q : Problems under Time Value of Money One

    One of the projects the US loan would fund is to build earthquake-resistant buildings. The projectwill begin in March 2013, last for two years and is expected to have the following expenditures:start-up costs of $200,000 paid at the beginning of the first month; renta

    		•