--%>

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 : Data Case Please assist with the

    Please assist with the attached Data Case assignment

  • Q : Earnings management What do you mean by

    What do you mean by Earnings management and what are their actions and activities?

  • Q : Types of agency Types of agency :

    Types of agency: Specific types of Agency include:A) Auctioneers: Are an agent of vendor until the fall of the hammer when they become an agent for the purchaser.B)

    Q : What is Stock Market Stock Market : To

    Stock Market: To trade company shares (or stock) and derivatives, a stock market or equity market is public entity where these shares and derivatives are sold at agreed price. These are to be listed on a stock exchange in order to trade publicly.

  • Q : Explain influences of financial

    Does financial leverage (i.e. debt) have any influence on the Free Cash Flow, upon the Cash Flow to Shareholders, upon the growth of the company and upon the value of the shares?

  • Q : Problem on rules of the International

    RainFlower Trading Limited is a wholesaler of electronic calculators in Hong Kong. It has been importing goods from a Philippine manufacturer for eight years. The Philippine manufacturer had accepted payments in advance in the past. Recently, because of political turm

  • 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 : Calculated betas when they give

    Calculated betas give different information if they are acquired by using weekly, monthly or daily data.

  • Q : How WACC should be computed to begin a

    I cannot seem to begin a valuation. In order to compute E + D = VA (FCF; WACC) I require the WACC and to compute the WACC I need D and E. Where must I start?

  • Q : Is book value the excellent proxy to

    Is book value the excellent proxy to the value of the shares?