--%>
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 required rate of return

    Tudor Online Publishing Corporation has tax rate of 35%, debt-to-equity ratio of 25%, and has (leveraged) beta 1.25. The riskless rate is 3% and the market return is 12%. Windsor Publishing Company is an all equity company and is in the same business. What is the requ

    		•
  • Q : Explain lognormal random walk based on

    Explain lognormal random walk based on Brownian motion.

    		•
  • Q : Define the term Stock Market crash

    Stock Market Crash was responsible for the Great Depression. Middle class families lost all their savings as they had gambled the market on margin.Those banks which were under the loan ofbrokers’ started removing money out of the savings account

    		•
  • Q : Zero Coupon Bonds-Corporate Bonds

    Describe the term Zero Coupon Bonds in Corporate Bonds?

    		•
  • 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 : Define Cash to cash cycle Cash to cash

    Cash to cash cycle: The concept of cash to cash cycle is financial performance standard, which is associated with the management of a firm’s working capital. The definition of cash to cash or cash conversion cycle is “the length of time a

    		•
  • Q : Explain the working of breakthrough for

    Explain the working of breakthrough in low-discrepancy sequences used for option valuation.

    		•
  • Q : Explain market efficiency hypothesis

    According to what I read inside a book, market efficiency hypothesis means that the expected average value of variations is zero in the shares price. Thus, the best estimate of the future price of a share is its price now, as this incorporates all the available inform

    		•
  • Q : Broad research methodologies Various

    Various broad research methodologies are available with which to study the development of accounting theory. a. Discuss the deductive, inductive, normative, and empirical research methods.  

  • Q : Calculating Beta when market

    A company with a market capitalization of $100 million has no debt and a beta of 0.8. What will its beta be after it borrows $50 million (giving that there are no other changes and no taxes)?

    		•