Question

In: Finance

FCOJ, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity...

FCOJ, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 35 percent debt. Currently there are 5,000 shares outstanding and the price per share is $49. EBIT is expected to remain at $43,6000 per year forever. The interest rate on new debt is 7 percent wand 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 ?

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.

c. Suppose the company does convert, but Ms. Brown prefers the current all-equity capital structure. Show how she could unloved her shares of stock to recreate the original capital structure.

d. Using your answer to part (c), explain why the company's choice of capital structure is irrelevant.

Solutions

Expert Solution

a)Calculation of Ms. Brown's cash flow

Earning available for distribution as dividend=EBIT=$43,600(as there is no tax)

Cash flow to Ms Brown=[$43,600/5,000]*100

=$872

b)Calculation of Ms. Brown's cash flow be under the proposed capital structure

New Capital structure:

Total value of firm=$49*5000=$245,000

Value of debt=$245,000*35%=$85,750

Value of equity=$245,000*65%=$159,250

No. of shares left=$159,250/$49=3250

Earning available for distribution as dividend=EBIT-Interest

=$43,600-(7%*$85,750)

=$37,597.50

Cash flow to Ms Brown=[$37,597.50/3250]*100

=$1156.85

c)When company issue 35% debt,she should sell 35% of her share and lend the sale proceed at 7%.

No. of shares sold=100*.35=35 shares

Ineterset on sale value of share=(35 shares*$49)*7%

=$120.05

Cash flow from dividend=[$37,597.50/3250]*65

=$751.95

Total cash flow to Ms Brown=$751.95+$120.05

=$872

d)Company choice of capital structure is irrelevant as their is no tax.


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