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 35 percent debt. There are currently 10,560 shares outstanding at a price per share of $50. EBIT is expected to remain constant at $60,696. The interest rate on new debt is 5 percent and there are no taxes.

a.	Rebecca owns $22,000 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, 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, 32.16.)
c.	Suppose the company does convert to the new capital structure. Show how Rebecca can maintain her current cash flow. (Do not round intermediate calculations and round your answer to 2 decimal places, 32.16.)

Answer 1

a). Value of Company = share outstanding * share price = 10,560 * $50 = $528,000

Rebecca's Cash Flow = Expected EBIT * [Rebecca's Ownership / Value of Company]

= $60,696 * [$22,000 / $528,000] = $60,696 * 0.0417 = $2,529

b). Shares Repurchased = [wD * Value of company] / Share Price

= [0.35 * $528,000] / $50 = $184,800 / $50 = 3,696

Net Income = EBIT - Interest

= $60,696 - [0.35 * $528,000 * 0.05] = $60,696 - $9,240 = $51,456

EPS = Net Income / [Share Outstanding - Shares Repurchased]

= $51,456 / [10,560 - 3,696] = $51,456 / 6,864 = $7.50

Shares Owned by Rebecca = Rebecca's Ownership / Share Price = $22,000 / $50 = 440 shares

Rebecca's Cash Flow = EPS * Shares owned by Rebecca = $7.50 * 440 = $3,298.46

c). She can maintain her current cash flow, by selling X shares and put the money into an account that earns interest at 5%.

Let's assume shares sold be X

Cash Flow = [(Shares Owned - Shares sold) * EPS] + [Interest Rate * Current Price * Shares Sold]

$2,529 = [(440 - X) * $7.50] + [0.05 * $50 * X]

$2,529 = $3,298.46 - [X * $7.50] + [$2.50 * X]

X * $5.00 = $3,298.46 - $2,529

X = $769.46 / $5 = 102.64., or 103 shares