The Rivoli Company has no debt outstanding and its financial position is given by the

following data:
Assets (book = market) !"###"###
$%&T '##"###
Cost of e(uity rs )#*
+tock price ,# )'
+hares outstanding" n# -##"###
Ta. rate" T(federal/plus/state) 0#*
The firm is considering selling bonds and simultaneously repurchasing some of its
stock1
&f it moves to a capital structure with !#* debt based on market values" its cost of e(uity"
rs" will increase to ))* to reflect the increased risk1 %onds can be sold at a cost " rd" of
2*1 Rivoli is a no/growth firm1 3ence" all its earnings ate paid out as dividends" and
earnings are e.pectationally constant over time1
a/ 4hat effect would this use of leverage have on the value of the firm5
6riginal value of the firm (7 = #):
8 = 7 9 + = # 9 ()')(-##"###) = !"###"###1
6riginal cost of capital:
4ACC = w
d
r
d
()/T) 9 w
e
r
s
= # 9 ()1#)()#*) = )#*1
4ith financial leverage (w
d
=!#*):
4ACC = w
d
r
d
()/T) 9 w
e
r
s
= (#1!)(2*)()/#10#) 9 (#12)())*) = :1;<*1
%ecause growth is =ero" the value of the company is:
8 =
1 -:< 1 -)0 " !0: " !
#:;< 1 #
) 0# 1 # ) )( ### " '## (
4ACC
) T ) )( $%&T (
4ACC
>C>
=

= 1
&ncreasing the financial leverage by adding ;##"### of debt results in an
increase in the firm?s value from !"###"### to !"!0:"-)01-:<1
b/ 4hat would be the price of Rivoli?s stock5
@sing its target capital structure of !#* debt" the company must have debt of:
7 = w
d
8 = #1!#(!"!0:"-)01-:<) = )"##0"0<01-:<1
Therefore" its debt value of e(uity is:
+ = 8 A 7 = -"!0!"2'#1
Alternatively" + = ()/w
d
)8 = #12(!"!0:"-)01-:<) = -"!0!"2'#1
The new price per share" ," is:
, = B+ 9 (7 A 7
#
)CDn
#
= B-"!0!"2'# 9 ()"##0"0<01-:< A #)CD-##"###
= )<120)1
c/ 4hat happens to the firm?s earnings per share after the recapitali=ation5
The number of shares repurchased" E" is:
E = (7 A 7
#
)D, = )"##0"0<01-:< D )<120) = <#"###1-'< <#"###1
The number of remaining shares" n" is:
n = -##"### A <#"### = )0#"###1
&nitial position:
$,+ = B('##"### A #)()/#10#)C D -##"### = )1'#1
4ith financial leverage:
$,+ = B('##"### A #1#2()"##0"0<01-:<))()/#10#)C D )0#"###
= B('##"### A 2#"!)-1')()/#10#)C D )0#"###
= -'2":)-1' D )0#"### = )1:0-1
Thus" by adding debt" the firm increased its $,+ by #1!0-1
d/ The '##"### $%&T given previously is actually the e.pected value from the
following probability distribution:
,robability $%&T
#1)# ()##"###)
#1-# -##"###
#10# '##"###
#1-# :##"###
#1)# )")##"###
7etermine the times interest earned ratio for each probability1 4hat is the probability of
not covering the interest payment at the !#* debt level5
!#* debt: T&$ =
&
$%&T
=
' 1 !)- " 2#
$%&T
1
,robability T&$
#1)# ( )10-)
#1-# -1:0
#10# 21))
#1-# ))1!:
#1)# )'1<0
The interest payment is not covered when T&$ F )1#1 The probability of this
occurring is #1)#" or )# percent1