--%>
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 : Relation between book value of shares

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

    		•
  • Q : Illustrates beta and capital structure

    We are valuing a company, many smaller than ours, so as to buy it. As that company is too smaller than ours this will have no influence on the capital structure and at the risk of the resulting company. It is the reason why I believe this the beta and the capital stru

    		•
  • Q : Who published a book regarding

    Who published a book regarding option formula and risk neutrality?

    		•
  • Q : Operational efficiency and

    Distinguish between Operational efficiency and informational efficiency?

    		•
  • Q : Did you see Vueling case Did you notice

    Did you notice the Vueling case? How is this possible that an investment bank sets the objective price of its shares in €2.50 per share upon the 2nd of October, 2007, just after replacing Vueling shares at €31 per share in J

    		•
  • Q : Is PER an excellent guide to investments

    Is PER an excellent guide to investments?

    		•
  • Q : What is Money Spreads Money Spreads :

    Money Spreads: Option trading strategies can be classified into various types like those pertaining to combination of one option with another option or set of options, other derivative contracts, stocks, etc. This paper focuses mainly on money spreads

    		•
  • Q : Illustrates reserves are real money or

    The part of the net income which is not distributed to shareholders goes to reserves (to shareholders’ equity). As dividends shows real money, reserves are real money as well. Is it true?

    		•
  • Q : Standard deviation of portfolios returns

    Assume that you have $50,000 which you want to invest in two companies, XYZ Books and ABC Audio. XYZ has a return of 10% and standard deviation 15%, while ABC has return of 15% with a standard deviation of 20%. The correlation coefficient between them is .5. Your port

    		•
  • Q : Problem on Zero coupon bonds

    Robertsons, Inc. is planning to enlarge its specialty stores into 5 other states and finance the expansion by issuing 15-year zero coupon bonds with a face value of $1,000. When your opportunity cost is 8 % and similar coupon-bearing bonds will recompense semi-annuall

    		•