Question

Star, 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 5,000 shares outstanding and the price per share is $60. EBIT is expected to remain at $25,000 per year forever. The interest rate on new debt is 6 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? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

  

Cash flow

$

  

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. (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

  

Cash flow

$

  

c.	Assume that Ms. Brown unlevers her shares and re-creates the original capital structure. What is her cash flow now? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Answer 1

a)
Cash flow = EBIT * (Number of shares own / Total number of shares)
= $25,000 * (100 / 5000)
= $500

Cash flow = $500

b)
Total value of firm = Total number of shares * Price per share
= 5,000 * $60
= $300,000

Debt = $300,000 * 30% = $90,000
Equity = $300,000 - $90,000 = $210,000

Number of shares = Equity / Price per share
= $210,000 / $60
= 3,500

Earnings for shareholders = EBIT - Interest
= $25,000 - ($90,000 * 6%)
= $19,600

Cash flow = $19,600 * (100 / 3500) = $560

Cash flow = $560

c)
Number of shares sold = 100 * 30% = 30 shares

Sale value of shares = 30 * $60 = $1,800

Interest income = $1,800 * 6% = $108

Earnings for shareholders = EBIT - Interest
= $25,000 - ($90,000 * 6%)
= $19,600

Dividend = $19,600 * 100 / 5000 = $392

Cash flow = Dividend + interest income
= $392 + $108
= $500

Cash flow = $500