Cyborg Mechatronics is entirely equity financed with 400 shares outstanding and a market capitalization of $18,750 (P=$46.875).Current financial data for Cyborg is provided in the table below for two states of nature,which correspond with two levels of sales.The standard deviation of EPS is $1.875.The CFO of Cyborg,John Conner,is considering a change in capital structure.In particular,he is thinking about borrowing $6,562.50.He will borrow the money by issuing perpetual bonds with a face value of $6,562.50 and a coupon rate of 6%.The borrowed money will be used to repurchase shares at $46.875 per share.Repurchased shares will be cancelled.Taxes are 0%.First,calculate the EPS in each state of nature if Cyborg borrows the money.Second,calculate the standard deviation of the EPS.What is the ratio of the standard deviation of EPS with the leveraged capital structure to the standard deviation under the current,all equity capital structure?

A) 0.54
B) 1.25
C) 1.54
D) 1.88
E) 2.89

Question

Cyborg Mechatronics is entirely equity financed with 400 shares outstanding and a market capitalization of $18,750 (P=$46.875) .Current financial data for Cyborg is provided in the table below for two states of nature,which correspond with two levels of sales.The standard deviation of EPS is $1.875.The CFO of Cyborg,John Conner,is considering a change in capital structure.In particular,he is thinking about borrowing $6,562.50.He will borrow the money by issuing perpetual bonds with a face value of $6,562.50 and a coupon rate of 6%.The borrowed money will be used to repurchase shares at $46.875 per share.Repurchased shares will be cancelled.Taxes are 0%.First,calculate the EPS in each state of nature if Cyborg borrows the money.Second,calculate the standard deviation of the EPS.What is the ratio of the standard deviation of EPS with the leveraged capital structure to the standard deviation under the current,all equity capital structure?

A) 0.54 
B) 1.25 
C) 1.54 
D) 1.88 
E) 2.89

Quizplus · Accepted Answer

If Ferris issues $6,562.50 worth of perpetual bonds, then it will have to make annual coupon payments (interest) of:
Interest = 0.06 × $6,562.50 = $393.75
If Universal uses the $6,562.50 to buy shares at $46.875/share, then it will purchase 140 shares leaving 260 (= 400 - 140) outstanding after the repurchase.
The earnings per share under the leveraged capital structure are given in the following table.
 11ea7fdb_fc5b_5232_a768_9b13b602ef4f_TB2902_00 Average EPS = ($1.37 + $7.14)/2 = $4.255 Variance =
0.5 × 11ea7fdb_fc5b_5233_a768_9b16f24b9ef2_TB2902_11 + 0.5 × 11ea7fdb_fc5b_5234_a768_2f07ba43dc2b_TB2902_11 = 8.321
Standard Deviation = 11ea7fdb_fc5b_5235_a768_fd2afd4ed10e_TB2902_11 = 2.885
Ratio = 11ea7fdb_fc5b_5236_a768_1dd7333fba01_TB2902_11 = 1.54

Cyborg Mechatronics Is Entirely Equity Financed with 400 Shares Outstanding