Question

PG&C, Inc. a consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 40 percent debt. Currently, there are 500 shares outstanding and the price per share is $65. EBIT is expected to remain at $3000 per year forever. The interest rate on new debt is 7 percent, and there are no taxes.

a. Ms. Johnson, 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. Johnson' cash flow be under the proposed capital structure of the firm? Assume that she keeps all 100 of her shares.

c. [Extra 10% Credit Question] Suppose PG&C does convert, but Ms. Johnson prefers the current all-equity capital structure. Show how she could unlever her shares of stock to recreate the original capital structure.

Answer 1

a) if there is 100% dividend payout, it means all the earnings per share will be transferred to shareholder and no earnings per share will be retained by the company, so earnings per share is net income / total no. of shares = 3000/500 = $6

Now Ms Johnson owns 100 shares of the stock so she will get Net income * no of shares owned by her = 6*100=$600

Please note that since there is all equity capital structure and no taxes hence EBIT = Net income

b) For new capital structure debt will be 40% and equity will become 100%-40% = 60%

The original value of company is number of equity shares * price per share = 500*$65=$32500. This value of company remains same after changing the debt structure. For this the company will issue new debt and buy back equivalent number of shares from market to maintain debt to equity ratio of 40:60. Debt issued is 40%*$32500=$13000 and equity becomes $19500, totaling $32500 as original value of the company.

Now the company will borrow 40% debt and pay 7% interest on this debt, with this debt company will buyback its equity shares from the market at the rate of $65 per share, hence the company will buyback 32500*40%/65 number of shares = 200 shares will be buyback by the company, hence remaining outstanding shares will be 500-200=300

New cash flow per share will be Net income/no of shares outstanding = (EBIT - Interest on debt)/no of shares = (3000-7%*13000)/300 = =2090/200=$6.97 per share.

Now Ms Johnson owns 100 shares, so the cash flow to her would be $6.97*100=$697

c) To take advantage of unlever, she will participate in 40% buyback and lend the company at 7%

So she will give 40% of her shares in buyback at $65 per share and will get 100*40%*65=$2600

Also she will lend this $2600 to the company and earn 7% interest = $2600*7%=$182

Now her cashflow is $182 as interest and $6.97 cash flow per share*60 remaining shares=$182 + $418=$600, which is same as (a) part, hence she is unaffected in this way