--%>
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 : Explain Cost of capital aspect Cost of

    Cost of capital aspect: Estimation of WCR is beneficial from the point of view of cost of capital too. A sound working capital position is beneficial from the point of view of both owners and lenders of the company. A sufficiently positive position me

    		•
  • Q : Data Case Please Assist with the

    Please Assist with the attached Data Case Assignment

    		•
  • Q : What is the expected risk premium on

    You have decided to invest 30 percent in X; 30 percent in Y; and 40 percent in Z. Theprobability of the state of the economy is Boom 25%; Normal 60%; and, Bust 15%. The rateof return for stock X is Boom .20; Normal .15; and, Bust .00. The rate of return for stock Y is

    		•
  • Q : Bond Price Information What is Bond

    What is Bond Price Information: Answer: Corporate bond market is not considered to be much transparent as it trades predominantly over the counter and investors do n

    		•
  • Q : Commercial Banking Assignment Part I

    Part I Guidelines and requirements: The questions in Part I of this assignment are based on the materials covered in Units 1 and 2. Please write a short-ess

    		•
  • Q : Types of Corporate Bonds What are the

    What are the various types of Corporate Bonds?

    		•
  • Q : Difference between intrinsic value and

    XYZ explained the difference between intrinsic value and book value in terms of the money spent on a college education. Please provide another example using a different simile.

    		•
  • Q : What are Stock exchanges Stock

    Stock exchanges: A stock exchange provides services useful for trading, issue and redemption of shares and other securities for traders and brokers. They will also provide facility for payment of income and dividends for listed securities. Securities

    		•
  • Q : Probability of dividend Universal

    Universal Corporation has the following dividend policy: if the earnings after taxes are less than $1 million, the dividend payout ratio will be 35%, but if these earnings are over $1 million, the dividend payout ratio will be 45%. The EBIT of Universal for next year

    		•
  • Q : Define Working capital requirement

    Working capital requirement: Is a financial term known as WCR, which is used to judge the operational liquidity of the business and it is a part of operational capital. A firm in spite of having a good profitability and assets may not have a good liqu

    		•