--%>
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 : Explain valuation method for

    We were assigned a valuation of a pharmaceutical laboratory’ shares. Which valuation method is further convenient?

    		•
  • Q : Convertible Bonds-Corporate Bonds State

    State the term Convertible Bonds in Corporate Bonds?

    		•
  • Q : How form a portfolio with higher

    Does this make any sense to form a portfolio comprised of companies along with a higher return/dividend?

    		•
  • Q : Explain the Monte Carlo evaluation of

    Explain the Monte Carlo evaluation of integrals.

    		•
  • Q : Is this better to repurchase shares or

    Assuming a company needs to distribute money to shareholders of it, is this better to repurchase shares or to distribute dividends?

    		•
  • 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 : Define Economy Impacts Economy Impacts

    Economy Impacts: An upcoming economy is indicated by rise in stock market, as stock market is primary indicator of a economic strength of a country. Progressing economy results in market boom. Yield of companies’ increases on improving economy,

    		•
  • Q : Problem on binomial option pricing model

    The share price of Cheung Kong (Holdings) Limited is currently at $100. Over each of the next two three-month periods, you expect its price will either increase by 10% or fall by 10% in each three-month period. If the Hong Kong interbank offered rate is 8% per annum w

    		•
  • Q : Calculate a positive net income for a

    Is this possible for a company with a positive net income and that does not distribute dividends to get itself in suspension of payments?

    		•
  • Q : Problems under Time Value of Money One

    One of the projects the US loan would fund is to build earthquake-resistant buildings. The projectwill begin in March 2013, last for two years and is expected to have the following expenditures:start-up costs of $200,000 paid at the beginning of the first month; renta

    		•