Question

The CEO of Kingdom Ltd. is considering whether or not to convert the firm’s current all-equity capital structure to one that has 50% debt (by retiring equity and leaving its total value unchanged). Currently, the firm has 1,000 shares outstanding and its share price is $40. The firm’s business is quite mature and it expects to generate stable annual earnings before interest and tax (EBIT) at $2,000 forever. As the firm has no further growth opportunities, it practices a 100% dividend payout policy. The market interest rate on borrowing is 8%. Brian Ng, a major shareholder of the firm, owns 20% of the total shares. Assume there is no tax and all other assumptions in the M&M model are met, and that the share price does not change during the capital structure conversion. a.Compute the annual payout to Brian under BOTH the all-equity and the levered capital structure. Assume that he will keep all his 200 shares under the levered capital structure. b.If the firm decides to change to the new capital structure, show how Brian can use homemade leverage to resemble his payoff under the all-equity capital structure. Explain and comment on the implication of this.

Answer 1

	a
		Annual Payout to Brian under all equity capital structure
		Total annual payout=EBIT	$2,000
		Total number of shares	1000
		Dividend payout per shares	$2	(2000/1000)
		Payout to Brian	$400	(2*200)
		Annual Payout to Brian under Levered capital structure
		Total unlevered capital=1000*$40	$40,000
		Equity in levered capital structure	$20,000	(40000*50%)
		Debt in levered capital structure	$20,000
		Total Number of shares	500
		Annual interest cost =$20000*8%	$1,600
		Net Income =EBIT-1600=2000-1600	$400
		Dividend payout per shares	$0.80	(400/500)
		Payout to Brian	$160	(0.8*200)
	b	Brian can sell 100 shares to the company and invest at 8% in the company's debt
		Number of shares balance	100
		Amount of investment in debt	$4,000	(40*100)
		Payout to Brian for balance 100 shares	$80	($0.8*100)
		Payment of interest to Brian	$320	(8%*4000)
		Total Payment to Brian	$400	(80+320)