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Solution 15-9

# Solution 15-9 - Problem 16-9ius(Capital Structure analysis...

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Problem 16-9ius (Capital; Structure analysis ) The Rivoli Company has no debt outstanding and its financial position is given by the following data: Assets (book = market) \$3,000,000 EBIT 500,000 Cost of equity rs 10% Stock price P0 \$15 Shares outstanding, n0 200,000 Tax rate, T(federal-plus-state) 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%. Rivoli is a no-growth firm. Hence, all its earnings ate paid out as dividends, and earnings are expectationally constant over time. a- What effect would this use of leverage have on the value of the firm? Original value of the firm (D = \$0): V = D + S = 0 + (\$15)(200,000) = \$3,000,000. Original cost of capital: WACC = w d r d (1-T) + w e r s = 0 + (1.0)(10%) = 10%. With financial leverage (w d =30%): WACC = w d r d (1-T) + w e r s = (0.3)(7%)(1-0.40) + (0.7)(11%) = 8.96%.

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Solution 15-9 - Problem 16-9ius(Capital Structure analysis...

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