Daddi Mac, Inc., doesn't face any taxes and has $250 million in assets, currently financed entirely with equity. Equity is worth $13 per share, and book value of equity is equal to market value of equity. Also, let's assume that the firm's expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below:
$$\begin{array} { c c c c }
\text { State } & \text { Recession } & \text { Average } & \text { Boom } \
\text { Probability of state } & 0.25 & 0.55 & 0.20 \
\text { Expected EBIT in state } & \$ 5 \text { million } & \$ 10 \text { million } & \$ 17 \text { million }
\end{array}$$
The firm is considering switching to a 25 percent debt capital structure, and has determined that they would have to pay a 10 percent yield on perpetual debt. What will be the standard deviation in EPS if they switch to the proposed capital structure?

Question

Daddi Mac, Inc., doesn't face any taxes and has $250 million in assets, currently financed entirely with equity. Equity is worth $13 per share, and book value of equity is equal to market value of equity. Also, let's assume that the firm's expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below:
$$\begin{array} { c c c c } 
\text { State } & \text { Recession } & \text { Average } & \text { Boom } \
\text { Probability of state } & 0.25 & 0.55 & 0.20 \
\text { Expected EBIT in state } & \$ 5 \text { million } & \$ 10 \text { million } & \$ 17 \text { million }
\end{array}$$
The firm is considering switching to a 25 percent debt capital structure, and has determined that they would have to pay a 10 percent yield on perpetual debt. What will be the standard deviation in EPS if they switch to the proposed capital structure?

Quizplus · Accepted Answer

The correct answer is A because the standard deviation of EPS will increase when the firm switches to a 25 percent debt capital structure. This is because the use of debt financing introduces financial leverage, which amplifies the variability of EPS.

Daddi Mac, Inc The Firm Is Considering Switching to a 25 Percent Debt