--%>
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 : Case Study 2 You have joined Zurich

    You have joined Zurich Pvt. Ltd as a Finance manager. You are given the following information: Zurich Pvt Ltd. is a diversified manufacturing firm dealing with electrical appliances. In 2012, the firm reported an operating income of Rs. 857.60 million and faced a tax rate of 35% on income. The firm

    		•
  • Q : Expected return for a portfolio What is

    What is the expected return for a portfolio consisting of 200 shares of Nike, 200 shares of Home Depot, and 400 shares of Intel if their expected returns are 10%, 8% and 12% respectively, and their current prices are $25, $50, and $25 per share respec

    		•
  • Q : Which method must use to valuate young

    Which method must we use to valuate young companies along with high growth but uncertain futures? Two illustrations were Boston Chicken and Telepizza while they began.

    		•
  • Q : What are capital investment The capital

    The capital investment appraisal techniques such as NPV, IRR, ARR, PV and Time value of money have become irrelevant post Celtic Tiger. Due to the depth of the recession companies do not have budgets to invest. Discus First use this information when you are writing this essay: 1.&

    		•
  • Q : EPS problem XY Corporation is an all

    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 deviatio

    		•
  • Q : Is depreciation is the loss of value of

    Is the depreciation is the loss of value of fixed assets?

    		•
  • Q : Problem on common stock The AB Corp

    The AB Corp stock has a β of 1.15 and it will pay a dividend of $2.50 next year. The expected rate of return of the market is 17% and the current riskless rate is 9%. The expected rate of progress of AB is 4%. Find the value of its common stock.

    		•
  • Q : Determine the future value What would

    What would the future value after 5 years of $100 be at 10% compound interest?

    		•
  • Q : Markets are expected to be Volatile

    When Markets are expected to be Volatile: For the bear and bull strategy to yield gains, it is essential that the trader takes a view on the direction of the market i.e. either bearish or bullish, and accordingly implement the strategic choice. More o

    		•
  • Q : Explain any indisputable model for

    Is there any indisputable model for valuing the brand of a company?

    		•