FIN 508 Assignment Week 6

Kerry Corporation needs $30 million in new capital, which it may acquire by selling bonds at par with 6% coupon or by selling stock at $40 (net) per share. The current capital structure of Kerry consists of $250 million (face value) of 3% coupon bonds selling at 80, and 12 million shares of stock selling at $42 apiece. After the new financing, the EBIT of Kerry is expected to be $50 million with a standard deviation of $20 million. The income tax rate of Kerry is 33%. Which method of financing do you recommend? What is the probability that you are right? [Use bonds, 72.41% ?] First, determine the critical EBIT, where the debt financing and equity financing provide equal EPS, by using E* = I + r(NP + F) (10.7) In this equation, I = interest on existing debt = .03(250) = $7.5 million r = coupon rate on new debt = .06 N = number of shares of stock at present = 12 million P = price per share of new equity = $40 F = amount of new financing needed = $30 million E* = 7.5 + .06*(12*40 + 30) = $38.1 million Since the company expects to make $50 million in EBIT, which is more than E*, it is better to sell bonds. ? To find the probability that you have made the right decision, find z as z = (38.1 – 50)/20 = -0.595 Draw the normal probability distribution curve, with z = 0 in the middle. The required z = -.595 is to the left of center. The area on the right of z = -.595 represents the probability of making the right decision. From the tables, we get the probability of being right P(being right) = .5 + .2224 + .5(.2257 – .2224) = 72.41% ? To check the answer at Excel, copy and paste the following in any cell. EXCEL =1-NORMDIST(38.1,50,20,TRUE) 6.2. Clinton Company is expecting to have EBIT next year of $15 million, with a standard deviation of $10 million. Clinton has $60 million in bonds with 5% coupon,

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