Question

FCOJ, Inc., a prominent consumer products firm, is debating whether to convert its all-equity capital structure to one that is 30 percent debt. Currently, there are 7,000 shares outstanding, and the price per share is $44. EBIT is expected to remain at $30,100 per year forever. The interest rate on new debt is 9 percent, and there are no taxes.

a.       Allison, a shareholder of the firm, owns 150 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.)

b.       What will Allison’s cash flow be under the proposed capital structure of the firm? Assume she keeps all 150 of her shares. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

c.       Assume that Allison 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.)

Answer 1

a) Earnings per Share EPS = Net Income / Shares = 30,100 / 7000 = $4.3

Since Allison owns 150 Shares, Cash flow will be = $4.3*150 = $645

b) First it is required to calculate EPS under proposed capital structure

Market Value of Firm (Current) = No of Shares * Market price per share = 7000*$44 = $308,000

Under new structure, value of Debt will be = 30% *308,000 = $92,400

Shares that can be repurchased with this amount = $92,400 / 44 = 2100

Now due to debt, Net income will decrease due to interest payment

NI = 30,100 - 9%*(92,400) = $21,784

Number of shares remaining now = 7000 - shares repurchased = 7000 - 2100 = 4900

EPS = 21784/4900 = $4.45

Cash Flow to Allison = $4.45*150 = $666.86

c) To replicate original structure, Allison should sell 30% shares and lend this money at 9%

Shares sold = 30%*150 = 45

CF =Shares Sold*Market price per share*Interest rate = 45*$44*9% = $178.2

Remaining share with Allison = 150-45 = 105

CF due to dividend = $4.45*105 = $466.8

Total CF = 178.2+466.8 = $645