--%>
Assignment Help - homework help

Financing EBIT problem

Rusk Inc needs $50 million in new capital that it might obtain by selling bonds at par with coupon of 12% or by selling stock at $40 (net) per share. The current capital structure of Rusk consists of $300 million (face value) of 10% coupon bonds selling at 90 and 10 million shares of stock selling at $43 apiece. Subsequent to the new financing, the EBIT of Rusk is expected to be $70 million with standard deviation of $30 million. Which technique of financing do you suggest? Determine the probability that you are correct?

E

Expert

Verified

From the given details,

When the issue of shares is involved, to raise $50 million at $40/share, the outstanding shares will increase by 1.25 million.

401_EBIt.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 $50 million by selling shares at $40 per share.

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

((EBIT - $36)(1 – 0.4) – 0)/10 = ((EBIT - $30)(1 – 0.4) – 0)/11.25
11.25*(0.6 EBIT – 21.6) = 10*(0.6 EBIT – 18)
6.75 EBIT – 243 = 6 EBIT – 180
0.75 EBIT = 63
EBIT = $84 million

Hence the probability that the above decision is right is

Z = ($84 – 70)/30 = 0.467
P(z) = 67.96%

Thus the equity financing must be recommended and the probability that this is right is 67.96%.

   Related Questions in Corporate Finance

  • Q : Historical return on stock market and

    The market risk premium is difference among the historical return upon the stock market and the risk-free rate, for yearly. Why is this negative for some years?

    		•
  • Q : Define Effective Utilization of Funds

    Effective Utilization of Funds: It is just the decision to maximize the return on investment of funds. When finance manager is not capable to raise the return by investing fund in profitable assets or other profitable projects, company’s busines

    		•
  • Q : Explain Financial Management Financial

    Financial Management: It means organizing, planning, directing and controlling the financial activities like procurement and use of funds of enterprise. This means exerting general management principles to the financial resources of enterprise. <

    		•
  • Q : Problem on price share and stock

    Brittney and Kim Wan Sun have successfully launched a successful talent agency, ABC. They expect the firm’s earnings and dividends to grow by 20% annually for the next 10 years and they establish a strong base and to grow at a constant 5% per year thereafter. AB

    		•
  • Q : Cost of Equity AB Corporation has 16%

    AB Corporation has 16% cost of equity, 35% tax rate, and debt-to-equity ratio of 30%. XY Corporation has 30% tax rate and debt-to-equity ratio of 40%. Both AB and XY are in the same business of selling automotive parts. If the riskless rate is 4% and the expected retu

    		•
  • Q : Relationship between the preferred

    Quetion: A private equity fund invests $100 million into a portfolio company and receives 100% of the preferred stock and 80% of the common stock of the company.  The preferred stock carries a face value of $1

    		•
  • Q : Relation between book value of shares

    Is the relation in between book value of shares or capitalization a good guide to investments?

    		•
  • Q : Does value of the company increase when

    According to the valuation method depends on tax shields, the value of the company (Vl) is the value of the unleveraged company (Vu) in addition with the value of tax shields (VTS), thus, the higher the interest and the higher the VTS. Therefore, does

    		•
  • Q : Active versus Passive fund managers

    Active vs. Passive fund managers: Passive fund managers adopt a long term buy and hold strategy. Usually, stocks are purchased so that the portfolio’s returns will track those of an

    		•
  • Q : Compute a company's cost of capital in

    How can we compute a company's cost of capital in emerging nations, particularly when there is no state bond that we could take as a reference?

    		•