The Rivoli Company has no debt outstanding, and its financial position is given by the following data:
Assets (book = market) 300,000
EBIT 500,000,
Cost of Equity, rs 10%
Stock Price, po $15
Shares outstanding, no 200,000
Tax Rate, t 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 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:
b.) What would be the price of Rivoli’s stock?
c.) What happens to the firm’s earnings per share after the recapitalization?
d.) The $500,000 EBIT given previously is actually the expected value from the following probability distribution:
Probability EBIT
0.1 100,000
0.2 200,000
0.4 500,000
0.2 800,000
0.1 1,100,000