# Question

HiLo, Inc., doesn’t face any taxes and has $100 million in assets, currently financed entirely with equity. Equity is worth $7 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 shown as follows:

STATE

PESSIMISTIC

OPTIMISTIC

Probability of state

0.45

0.55

Expected EBIT in state

$5 million

$19 million

The firm is considering switching to a 40 percent debt capital structure, and has determined that they would have to pay a 12 percent yield on perpetual debt in either event. What will be the standard deviation in EPS if they switch to the proposed capital structure?

STATE

PESSIMISTIC

OPTIMISTIC

Probability of state

0.45

0.55

Expected EBIT in state

$5 million

$19 million

The firm is considering switching to a 40 percent debt capital structure, and has determined that they would have to pay a 12 percent yield on perpetual debt in either event. What will be the standard deviation in EPS if they switch to the proposed capital structure?

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