Question

Homemade Leverage Conspicuous Consumption, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 35 percent debt. Currently, there are 7,600 shares outstanding and the price per share is $55. EBIT is expected to remain at $36,000 per year forever. The interest rate on new debt is 8 percent, and there are no taxes.

a. Ms. Brown, a shareholder of the firm, owns 100 shares of stock. What is her cash flow under the
current capital structure, assuming the firm has a dividend payout rate of 100 percent?

b. What will Ms. Brown’s cash flow be under the proposed capital structure of the firm? Assume that she
keeps all 100 of her shares.

c. Suppose the company does convert, but Ms. Brown prefers the current all-equity capital structure.
Show how she could unlever her shares of stock to re-create the original capital structure.

d. Using your answer to part (c), explain why the company’s choice of capital structure is irrelevant.

Answer 1

1. Ms. Brown Cash Flow = 36,000/7,600 * 100 = 473.68, if the dividend payout ratio is 100%.
2. Borrow = 7600*55*35% = 146300 New shares = 7600 - 146300/55 = 4940 Cash Flows = 36000 - 146300*8%/ 4940 * 100 = 491.82.
3. To Unlever : Firm Borrows = She lends 35% of her wealth. Firm Buybacks = She sells 35% of her shares & lends at 8% Interest Income = 35% * 100* 55 = 1925 * 8% = 154 Cash Flow = 4.92 * 65 + 154 = 473.8
4. Since the shareholders can recreate any capital structure they like, they wont pay for a premium for a particular structure. Therefore, capital structure is irrelevant.