--%>
Assignment Help - homework help

Problem on raising new capital

AB Corporation has 3 million shares of common stock selling at $19 each. It also contains $25 million in bonds with coupon rate of 8%, selling at par. AB requires $10 million in new capital that it can raise by selling stock at $18, or bonds at 9% interest. The expected EBIT subsequent to the new capitalization is $6 million, with a standard deviation of $3 million. Determine the preferred method of raising new capital? What is the probability that you are correct?

E

Expert

Verified

From the given details,

When the issue of shares is involved, to raise $10 million at $18/share, the outstanding shares will increase by 0.56 million.

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 $10 million by selling shares at $18 per share.

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

((EBIT - $2900)(1 – 0.4) – 0)/3000 = ((EBIT - $2000)(1 – 0.4) – 0)/3555.56
3555.56*(0.6 EBIT – 1740) = 3000*(0.6 EBIT – 1200)
2133.33 EBIT – 6,186,667 = 1800 EBIT – 3,600,000
333.333 EBIT = 2,586,667
EBIT = $7,760 (in thousands)

Hence the probability that the above decision is right is

Z = ($7760 – 6000)/3000 = 0.5867
P(z) = 72.13%

Thus the equity financing must be recommended and the probability that this is right is 72.13%.

   Related Questions in Corporate Finance

  • Q : Analysis on Stock Prices Using the last

    Using the last 3 years of closing stock prices on the first trading day of each month from January,  2010 through December 2012 for Apple (APPL) and the S&P 500 (market) for the same date range 1)    &n

    		•
  • Q : Vanilla Bonds-Corporate Bonds Define

    Define the term Vanilla Bonds regarding Corporate Bonds?

    		•
  • Q : Relation between book value of shares

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

    		•
  • Q : What is Financial Analysis Financial

    Financial Analysis: It is the investigation and interpretation of financial statements and associated financial reports. Trained and certified accountants generally complete this kind of analysis. The role of a financial analyst is to

    		•
  • Q : Compute the present value of the

    Is this possible to value companies by computing the present value of the Economic Value Added (EVA)?

    		•
  • Q : Explain Indenture Explain the term

    Explain the term Indenture and also describe their provisions?

    		•
  • Q : Explain useful properties of

    Explain useful properties of low-discrepancy sequence theory or quasi random number theory.

    		•
  • 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 : 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 : Explain definition of put–call parity

    Explain the definition of put–call parity described by Reinach.

    		•