Question

Pagemaster 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 45 percent debt. There are currently 2,000 shares outstanding at a price per share of $50. EBIT is expected to remain constant at $21,996. The interest rate on new debt is 6 percent and there are no taxes.

a. Rebecca owns $20,000 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, 32.16.)

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, 32.16.)

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 2 decimal places, 32.16.)

Answer 1

a). Company's Value = No. of shares outstanding x Share Price = 2,000 x $50 = $100,000

Rebecca's Cash Flow = [Share Value owned / Value of Company] x EBIT

= [$20,000 / $100,000] x $21,996 = 0.2 x $21,996 = $4,399.20

b). Shares Repurchased = [wD x Company's Value] / Share Price

= [0.45 x $100,000] / $50 = $45,000 / $50 = 900 shares

Net Income = EBIT - [wD x kD x Company's Value]

= $21,996 - [0.45 x 0.06 x $100,000]

= $21,996 - $2,700 = $19,296

EPS = Net Income / [No. of Shares Outstanding - Shares Repurchased]

= $19,296 / [2,000 - 900] = $19,296 / 1,100 = $17.54

Shares owned by Rebecca = Value of Investment / Share Price = $20,000 / $50 = 400 shares

Rebecca's Cash Flow = No. of shares owned x EPS = 400 x $17.54 = $7,016.73

c). X = Shares Sold

[(Share Owned - X) * EPS] + [kD * Share Price * X] = Rebecca's Cash flow

[(400 - X) * $17.54] + [0.06 * $50 * X] = $4,399.20

$7,016.73 - [$17.54 * X] + [$3 * X] = $4,399.20

$14.54 * X = $2,617.53

X = $2,617.53 / $14.54 = 180 shares