Question

Star, Inc. a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 35% debt. Currently there are 6,000 shares outstanding and the price per share is $58. EBIT is expected to remain at $39,600 per year, forever. The interest rate on new debt is 7%, and there are no taxes.

a) Ms. Brown, a shareholder in 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%.

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

Answer 1

Current D/E = 0; Equity = 100%

V = Shares outstanding x share price = 6,000 x $58 = $348,000

Proposed D/E = 0.35 / 0.65 = 0.54

a). NI / No. of Shares = $39,600 / 6,000 = $6.6 per share

Payout = 100%

Cash Flow = $6.6 x 100 = $660

b). Under the proposed D/E, the firm has to:

1). Borrow 35% of V = $348,000 x 35% = $121,800

2). Buyback E at $58

New #Shares Outstanding = Original Shares - Shares Repurchased

= 6,000 - ($121,800 / $58) = 6,000 - 2,100 = 3,900

NI / No. of Shares = [EBIT - Interest] / New #Shares

= [$39,600 - ($121,800 x 7%)] / 3,900 = $31,074 / 3,900 = $7.97 per share

Cash Flow = $7.97 x 100 = $797