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 25 percent debt. There are currently 8,100 shares outstanding at a price per share of $50. EBIT is expected to remain constant at $44,000. The interest rate on new debt is 7 percent and there are no taxes.

a.	Rebecca owns $17,000 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, e.g., 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, e.g., 32.16.)
c.	Suppose the company does convert to the new capital structure. Show how Rebecca can maintain her current cash flow.

Answer 1

a). Value of Company = No. of Shares * Share Price = 8,100 * $50 = $405,000

Rebecca's Cash Flow = % ownership of Rebecca * Net Income

= (17,000 / 405,000) * $44,000 = $1,846.91

b). Shares Repurchased = Amount of Debt / Market Share Price = [0.25 * $405,000] / $50 = 2,025

Net Income = [EBIT - Interest] * [1 - t]

= [$44,000 - (0.25 * $405,000 * 0.07)] * [1 - 0]

= $44,000 - $7,087.50 = $36,912.50

EPS = Net Income / Shares Outstanding = $36,912.50 / (8,100 - 2,025) = $6.08

Rebecca Cash Flow = Shares Owned * EPS

= [$17,000 / $50] * $6.08 = $2,065.88

c). She has to sell some of shares and put that money in a account earning 7%

Lets assume no. of shares sold = x

Current Cash Flow = [(Shares Owned - Shares sold) * EPS] + [Rate of Return * Value of Shares invested]

$1,846.91 = [(340 - x) * $6.08] + [0.07 * ($50 * x)]

1,846.91 = 2,065.88 - [x * $6.08] + [3.50 * x)]

[x * $6.08] - [3.50 * x)] = 2065.88 - 1846.91

x * 2.58 = 218.97

x = 218.97 / 2.58 = 85

So, she can sell 85 shares