Running head: GB550 Assignments Unit 6

Kaplan University Graduate School of Business and Management GB550 Financial Management

GB550 Dr. Dale Prondzinski

Written by: Joel Westfield

10 July 2011

GB550 Assignments Unit 6 Corporate Valuation and Capital Structure Question 13-5: How is it possible for an employee stock option to be valuable even if the firms stock price fails to meet shareholders expectations?

An employee can receive a very significant return by exercising a stock option even if his or her companys stock price falls short of shareholders expectations (Brigham & Ehrhardt 2010). To illustrate this consider the employee who is granted options on 20,000 shares of his companys stock with an exercise price of $75 a share. Further suppose that the risk-free rate is 5%, the companys beta is 1.24, and the market risk premium is 6%. According to the CAPM model, the required return of the companys stock is 12.5% (0.05 + (0.06)(1.25)). At the end of 5 years, the employee exercises his options, purchases 20,000 shares of his companys stock at $75 a share and sells it for $105 soon thereafter. The employee receives $600,000. The annual growth rate of the companys stock was 6.96%, far less than the 12.5% shareholders were expecting. Nevertheless, the employees stock option was very valuable. Problem 15-8: The Rivoli Company has no debt outstanding, and its financial position is given by the following data:
Assets (book = market) EBIT Cost of equity, rs Stock price, Po Shares outstanding, no Tax rate, T (federal-plus-state) $3,000,000 $500,000 10% $15 200,000 40%

The firm is considering selling bonds and simultaneously repurchasing some of its stock. If it moves to a capital structure with 30% debt based on market values, its cost of equity, rs, will increase to 11% to reflect the increased risk. Bonds can be sold at a cost, rd, of 7%.

GB550 Assignments Unit 6

Rivoli is a no-growth firm. Hence, all its earnings are paid out as dividends. Earnings are expected to be constant over time. a. What effect would this use of leverage have on the value of the firm? By changing its capital structure to 30% debt and 70% equity, the value of the firm will increase from $3,000,000 to $3,348214.29. This is due to the decrease in Rivolis WACC as rd < rs. A capital structure of 100% equity would have a WACC of 10%, as given in the problem. Changing the capital structure to include 30% debt changes WACC as follows: WACC = wsrs + wdrd(1-T) = (0.70)(0.11) + (0.30)(0.07)(1-0.40) = 0.0896 = 8.96% At the initial capital structure, the value of operations was as follows: FCF / WACC = EBIT(1-T) / WACC = $500,000 x 0.6 / 0.10 = $3 million. After recapitalizing to 30% debt, the value of operations is as follows: FCF / WACC = EBIT(1-T) / WACC = $500,000 x 0.6 / 0.0896 = $3,348214.29 b. What would be the price of Rivolis stock? The recapitalization increases the price of Rivolis stock to $16.74 a share. Brigham & Ehrhardt (2010) provide the formula: PPost = (VopNew DOld) / nPrior = $3,348,214.29 / 200,000 = $16.74 c. What happens to the firms earnings per share after the recapitalization? After recapitalization, Rivolis EPS is $1.87. This is calculated as follows: Net income (with 30% debt) = (EBIT rdD)(1- T) = [$500,000 (0.07)($900,000)](0.6) = $262,200 Number of shares after stock repurchase = nPost = nPrior (DNew DOld) / PPrior = 200,000 ($900,000 / $15) = 140,000 EPS = Net income / nPost = $262,000 / 140,000 = $1.87

GB550 Assignments Unit 6 d. The $500,000 EBIT given previously is actually the expected value from the following probability distribution:
Probability 0.1 0.2 0.4 0.2 0.1 EBIT ($100,000) $200,000 $500,000 $800,000 $1,100,000

Determine the times-interest-earned ratio for each probability. What is the probability of not covering the interest payment at the 30% debt level? There is a 10% probability of not covering the interest payment at the 30% debt level. At a 30% debt level, Rivoli would have $900,000 debt. The rd = 0.07. So, the annual interest payment would be $900,000 x 0.07 = $63,000. The following table shows the Timesinterest-earned (EBIT / Interest payment) at each probability:
Probability 0.1 0.2 0.4 0.2 0.1 EBIT ($100,000) $200,000 $500,000 $800,000 $1,100,000 TIE Ratio -1.59 3.17 7.94 12.70 17.46

There is a 10% probability that Rivoli would not cover its interest payment.

GB550 Assignments Unit 6 References

Brigham, E., Ehrhardt, M. (2010). Financial management theory and practice (13th ed.). Mason, OH: South-Western Cengage Learning