Question

Lydic Enterprises is considering a change from its current capital structure. The company currently has an all-equity capital structure and is considering a capital structure with 35 percent debt. There are currently 6,000 shares outstanding at a price per share of $90. EBIT is expected to remain constant at $75,000. The interest rate on new debt is 12 percent and there are no taxes.

a. Rebecca owns $36,000 worth of stock in the company. If the firm has a 100 percent payout, what is her cash flow? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Shareholder cash flow _____ $

b. What would her cash flow be under the new capital structure assuming that she keeps all 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 the company does convert to the new capital structure. Show how Rebecca can maintain her current cash flow. (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. Current total capital = $90*6000 = $540,000

Net Income = EBIT = $75,000 (As there is no interest or tax to be paid)

EPS (shareholder cash flow) = $75,000/6000 = $12.5

Rebecca's Cash flow = ($36,000/$540,000) * $75,000 = $5,000

b. Under the new capital structure, Total Equity = $540,000 * 0.65 = $351,000

Total Debt = $450,000 * 0.35 = $189,000

Shares Repurchased = (0.35 * 540,000)/$90 = 2100

Share Count = 6000-2100 = 3900

Net Income = EBIT - Interest = $75,000 - (12% of $189,000) = $52,320

  EPS (shareholder cash flow) = $52,320/3900 = $13.41

Rebecca's Cash flow = ($36,000/$351,000) * $52,320 = $5366.15

c. So as to maintain her cash flow, i.e., $5000, no. of shares she should hold = $5000/$13.41 = 372.70 i.e 373 shares

Earlier no. of shares held by Rebecca = $36,000/ $90 = 400 shares

No. of shares Rebecca should sell = 400 - 373 = 27 shares