Question

FCOJ, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 30 percent debt. Currently, there are 5,700 shares outstanding and the price per share is $54. EBIT is expected to remain at $20,585 per year forever. The interest rate on new debt is 12 percent, and there are no taxes.

a. Melanie, a shareholder of the firm, owns 260 shares of stock. What is her cash flow under the current capital structure, assuming the firm has a dividend payout rate of 100 percent? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
  
Shareholder cash flow            $

b. What will Melanie’s cash flow be under the proposed capital structure of the firm? Assume that she keeps all 260 of her shares. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
  
Shareholder cash flow            $

c. Suppose FCOJ does convert, but Melanie prefers the current all-equity capital structure. Show how she could unlever her shares of stock to recreate the original capital structure. (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

Number of shares stockholder should sell

Answer 1

a)
Cash flow under the current capital structure, assuming the firm has a dividend payout rate of 100 percent
= Shares owned x (EBIT / Total shares)
= 260 x 20585 / 5700
= 938.96491228
= 938.96 (rounded off to 2 decimals)

b)
Computation ofMelanie’s cash flow be under the proposed capital structure of the firm
Total equity capital before debt issue = 5700x54 = 307,800
New capital = 307800 x (1 - 30%) = 307800 x 0.7 = 215460
No. of shares after debt issue = 215460 / 54 = 3990
Cash flow for 260 shares
= 260 x ((20585 - (307800 x 0.3x 0.12)) / 3990)
= 260 x 11080.8 / 3990
= 260 x 2.77714285714
= 722.057142856
= 722.06 (rounded off to 2 decimals)
Melanie’s cash flow be under the proposed capital structure of the firm
(Share holder cashflow) = 722.06

c)
Number of shares stockholder should sell
= 30% x 260
= 78 shares