--%>
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 : Define Initial public offering or IPO

    Initial public offering: An initial public offering (IPO) otherwise called as stock market launch, is the first time company selling stock to public. Usually raised for capital expansion and to become publicly traded company. Investment banking firms

    		•
  • Q : Operational efficiency and

    Distinguish between Operational efficiency and informational efficiency?

    		•
  • Q : Commercial bank problems For an

    For an enhanced understanding of banking industry, it is significant to look at the atmosphere in which commercial banks operate. Production growth and globalization are two main forces reshaping the banking industry nowadays. The following two questions are associate

    		•
  • Q : Is ROE a correct measurement of return

    The ROE is the ratio among net income and Shareholders’ equity. The meaning of Return on Equity is return to shareholders. Therefore, is ROE a correct measurement of the return to shareholders?

    		•
  • Q : Relationship between the preferred

    Quetion: A private equity fund invests $100 million into a portfolio company and receives 100% of the preferred stock and 80% of the common stock of the company.  The preferred stock carries a face value of $1

    		•
  • Q : Who explain match theoretical & market

    Who demonstrated that how to match theoretical and market prices for normal bonds?

    		•
  • Q : Bond price problem ABC Corp is issuing

    ABC Corp is issuing a 10-year bond with a coupon rate of 7 %. The interest rate for similar bonds is at present 9 %. Supposing annual payments, what is the current value of the bond? (Round to the closest dollar.) (a) $872 (b) $1,066 (c) $990 (d) $945.

    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 : 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 : Expected return for a portfolio What is

    What is the expected return for a portfolio consisting of 200 shares of Nike, 200 shares of Home Depot, and 400 shares of Intel if their expected returns are 10%, 8% and 12% respectively, and their current prices are $25, $50, and $25 per share respec

    		•