problem: The XYZ Co. is assessing its current capital structure & its implications for the welfare of its security holders. XYZ is currently financed entirely with common stock, of which 1,000 shares are outstanding. Given the risk of the underlying cash flows [EBIT, earnings before interest & taxes] generated by XYZ, investors currently require a twenty percent return on the XYZ common.

The company pays out all expected earnings as dividends to common stockholders, & these expected earnings are based on the expected operating earnings (EBIT) generated by the firm's assets. XYZ estimates that operating income may be either 1,000, 2,000 or 4,200 with respective probabilities of 0.1, 0.4 & 0.5 depending on future economic conditions. Further, the firm expects to produce a level stream of EBIT in perpetuity. Assume that the corporate & personal tax rates are equal to zero.

[A]   Given the above facts, compute

1. the value of the firm;
2. the expected earnings per share of common stock;
3. the firm's average cost of capital.
4. the market value of a common share;

[B]   The president of XYZ has come to the conclusion that shareholders would be better off if the company had equal proportions of debt & equity. He therefore proposes to issue $7,500 of debt at an interest rate of ten percent & use the proceeds to repurchase stocks. Examine this proposition by computing

• the value of equity;
• the price of one common share;
• the new value of the firm;
• the value of debt;
•  the required rate of return on equity;
•  the firm's average cost of capital.