--%>
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 : 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 : Convertible Bonds-Corporate Bonds State

    State the term Convertible Bonds in Corporate Bonds?

    		•
  • Q : Explain investment of bank for

    When my company is not listed, therefore the investment banks apply an illiquidity premium. In fact, they say this is an illiquidity premium but then they call this a small cap premium. Only one of the banks, apparently based upon Tit

    		•
  • Q : Explain value of shares is Is this

    Is this correct that the value of the shares is, the “value of the results’ capitalization” that, as per to the Institute of Accounting and Auditing (ICAC) shows “the sum of the expected future results of the company throughout a certain period

    		•
  • Q : What is the value of stock Brushy

    Brushy Mountain Mining Company's ore reserves are being depleted, so its sales are falling. Also, its pit is getting deeper each year, so its costs are rising. As a result, the company's earnings and dividends are declining at the constant rate of 5% per year. I

    		•
  • Q : Efficient Market Hypotheses Write

    Write Efficient Market Hypotheses in brief?

    		•
  • Q : What is the sales of the firm The

    The financial ratios of a firm are as follows. Current ratio = 1.33 Acid-test ratio = 0.80 Current liabilities = 40,000 Inventory turnover ratio = 6  What is the sales of the firm?

    		•
  • Q : Finance You expect KT industries (KTI)

    You expect KT industries (KTI) will have earnings per share of $3 this year and expect that they will pay out $1.50 of these earnings to shareholders in the form of a dividend. KTI's return on new investments is 15% and their equity cost of capital is 12%. The value of a share of KTI's stock is clos

    		•
  • Q : Strategy of Bull Spread State when

    State when market is expected to go up then what is the Strategy of Bull Spread?

    		•
  • Q : Explain the structure

    Our company (A) is going to buy the other company (B). We need to value the shares of B and, thus, we will use three options of the structure Debt/Shareholders’ Equity in order to obtain the WACC as: 1) Present structure of A

    		•