Question

Dronalution, Inc. a major drone manufacturer is currently all equity financed. They are contemplating converting all equity capital structure to one that is 30% debt, financed at 6% interest. The company currently has 5,000 shares outstanding at a price of $53 per share. EBIT is $35,000 and expected to remain at this amount. Respond to the following. Ignore taxes.

A. Mr. Fisher one of the firm's shareholders, owns 200 shares of the firm's stock. What is his cash flow under the current capital structure? Assume a dividend payout rate of 100 percent.

B. What will Mr. Fisher's cash flow be under the proposed capital structure of the firm? Assume that he keeps all of his shares.

C. If Dronalution does convert, but Mr. Fisher prefers the all-equity capital structure. How could he unlever his shares of stock to recreate the original capital structure?

D. Explain the concept of homemade leverage and why Dronalution's choice of capital structure is irrelevant.

Answer 1

A. EBIT = 35000. Number of shares = 5000. Since 100% dividends, Dividend per share = 35000/5000 = $7

Since Mr. Fisher owns 200 shares, Cash flow = 7*200 = $1,400

B. total value = 5000*53 265,000

30% debt = 0.3*265000 = 79,500

Number of share to be repurchased =79500/53 = 1500

Number of shares remaining = 5000-1500 = 3500

EBIT = 35000

Interest = 6%*79,500 = 4770

Net Income = 35000-4770 = 30230

Dividend per share =30230/3500 = 8.637/share

Mr. Fishers cash flow = 8.637*200 = $1,727.43

C. if dronalation does conver, he can remain in all equity by selling all his shares of this business and buy shares of a another 100% equity firm so there is no debt in the company he ownes

D. One can implement home made leverage and borrow 30% of their investment from a bank at aborrowal rate of 6% and invest it in the shares again and this would create the same effect as taking additional debt