Question

Conspicuous Consumption, 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 18,000 shares outstanding and the price per share is $49. EBIT is expected to remain at $63,000 per year forever. The interest rate on new debt is 10 percent, and there are no taxes.

a. Ms. Brown, a shareholder of the firm, owns 250 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 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 250 of her shares. (Do not round intermediate calculations and round your 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 answer to 2 decimal places, e.g., 32.16.)

Cash flow           $

Answer 1

a) Under current structure,

EBIT = Net Income. 100% of net income is paid out as dividend to shareholders

Net Income = 63,000

Number of shares outstanding = 18,000

Per share dividend = 63,000/18,000 = $3.5

Dividend received by Ms. Brown = $3.5 * 250 = $875 (Answer a)

b) Current value of capital = $49 * 18,000 = $882,000

30% of this would be recapitalized with debt = 30% * $882,000 = $264,600

Number of shares repurchased (at $49) = $264,600/$49 = 5,400

Number of shares now outstanding = 18000 - 5400 = 12,600

Net Income = EBIT - Interest Expense = 63,000 - (10% * 264,600) = 36,540

Per share dividend = 36,450/12,600 = $2.90

Dividend received by Ms. Brown = $2.9 * 250 = $725 (Answer b)

c) In order to unlever her shares and re-create the original capital structure, she sells 30% of her shares and lends the amount at 10%.

30% * 250 = 75 shares

75 shares * $49 = 3,675

Interest income = 3675 * 10% = $367.7

Dividend Income = (250 - 75) * $2.9 = $507.5

Total income = $367.5 + $507.5 = $875 (Answer c)