Question

My-Grain Limited is debating whether to set up with an all equity capital structure or one that is 60 per cent debt. An all-equity structure would have 12,000 shares outstanding and the price per share is $2.5. EBIT is expected to remain at $3000 per year forever. The interest rate on the debt is 9 per cent, and there are no taxes. The founding director, Mr Painful intends to have 2,000 shares.

a. What is Mr. Painful’s cash flow under the all equity capital structure?
b. What will Mr. Painful’s cash flow be with debt in the capital structure? Assume that he holds all 2,000 shares.
c. Suppose My- Grain uses debt but Mr. Painful prefers the all equity capital structure. Show how he could un-leverage his investment to recreate the capital structure?
d. Explain why the capital structure My-Grain chooses is irrelevant?

Answer 1

	Option 1	Option 2
Equity ($ 2.5 of 12000)	30000	12000( with 4800 shares of $2.5 each0
Debt	0	18000
Cost of debt	0	9%
EBIT	3000	3000
(Interest)		-1620
Net Income to share holders	3000	1380
Return to on equity	0.25	0.2875
Return to Mr. Painful for 2000share	500	575

Answer a) Return to Mr Pain ful = $ 500 in unleveragad condition ( all equity)

Answer b) Return to Mr Pain ful = $ 575 in leveragad condition ( equity and Debt)

Answer c) He can purcahse 800 shares and debt from remaining fund i.e. 1200* 2.5 = 3000.

Total CF = 800 shares × 0.2875cents + 0.09 × $3000 = 230 + 270 = $500 as per (a)

Answer d)

The capital structure is generally irrelevant to shareholders because the shareholders can create their own leverage position which will give them the payoff they desire.