# Question

Daddi Mac, Inc., doesn’t face any taxes and has $350 million in assets, currently financed entirely with equity. Equity is worth $37 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 are dependent upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities shown as follows:

STATE

RECESSION

AVERAGE

BOOM

Probability of state

0.25

0.55

0.20

Expected EBIT in state

$5 million

$10 million

$17 million

The firm is considering switching to a 20 percent debt capital structure, and has determined that they would have to pay an 8 percent yield on perpetual debt regardless of whether they change their capital structure. What will be the standard deviation in EPS if they switch to the proposed capital structure?

STATE

RECESSION

AVERAGE

BOOM

Probability of state

0.25

0.55

0.20

Expected EBIT in state

$5 million

$10 million

$17 million

The firm is considering switching to a 20 percent debt capital structure, and has determined that they would have to pay an 8 percent yield on perpetual debt regardless of whether they change their capital structure. What will be the standard deviation in EPS if they switch to the proposed capital structure?

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