Running head: GB550 Assignments – Unit 6

Kaplan UniversityGraduate School of Business and Management

GB550 Financial Management

GB550Dr. Dale Prondzinski

Written by:Joel Westfield

10 July 2011

GB550 Assignments – Unit 6 2

Corporate Valuation and Capital Structure

Question 13-5: How is it possible for an employee stock option to be valuable even if the

firm’s 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 company’s 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

company’s stock with an exercise price of $75 a share. Further suppose that the risk-free rate is

5%, the company’s beta is 1.24, and the market risk premium is 6%. According to the CAPM

model, the required return of the company’s 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 company’s stock at

$75 a share and sells it for $105 soon thereafter. The employee receives $600,000. The annual

growth rate of the company’s stock was 6.96%, far less than the 12.5% shareholders were

expecting. Nevertheless, the employee’s 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) $3,000,000

EBIT $500,000

10%

$15

200,000Tax rate, T (federal-plus-state) 40%

Cost of equity, rs

Stock price, Po

Shares outstanding, no

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 3

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 Rivoli’s 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 Rivoli’s stock?

The recapitalization increases the price of Rivoli’s 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 firm’s earnings per share after the recapitalization?

After recapitalization, Rivoli’s 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 4

d. The $500,000 EBIT given previously is actually the expected value from the

following probability distribution:

Assets (book = market)

EBIT

Cost of equity, rs

Stock price, Po

Shares outstanding, no

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 Times-

interest-earned (EBIT / Interest payment) at each probability:

Assets (book = market) $3,000,000

EBIT $500,000

10%

$15

200,000

Cost of equity, rs

Stock price, Po

Shares outstanding, no

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

GB550 Assignments – Unit 6 5

References

Brigham, E., Ehrhardt, M. (2010). Financial management theory and practice (13th ed.). Mason,

OH: South-Western Cengage Learning