Question

Consider

Dronalution, Inc. a major drone manufacturer is currently all equity financed. They are contemplating converting all equity capital structure to one that is 30% debt, financed at 6% interest. The company currently has 5,000 shares outstanding at a price of $53 per share. EBIT is $35,000 and expected to remain at this amount. Respond to the following. Ignore taxes.

Discuss

• Mr. Fisher one of the firm's shareholders, owns 200 shares of the firm's stock. What is his cash flow under the current capital structure? Assume a dividend payout rate of 100 percent.
• What will Mr. Fisher's cash flow be under the proposed capital structure of the firm? Assume that he keeps all of his shares.
• If Dronalution does convert, but Mr. Fisher prefers the all-equity capital structure. How could he unlever his shares of stock to recreate the original capital structure?
• Explain the concept of homemade leverage and why Dronalution's choice of capital structure is irrelevant.

Answer 1

Answer :

Calculation of Cash flow to fisher under current capital structure :

Number of shares owned by Fisher = 200 shares

Earnings before Interest and tax = $35,000

Number of shares outstanding = 5,000 shares

Ignoring effect of  taxes and there is no debt,

Net Income = EBIT = $35,000

Dividend per share = Net Income / Number of shares outstanding

Dividend per share = $35,000 / 5,000 = $7 per share

Cash flow to fisher = Dividend per share x Number of shares owned by Fisher

= $7 x 200 = $1,400

So, Cash flow to fisher under current capital structure = $1,400

Calculation of Cash flow to fisher under Proposed capital structure :

Total Capital before debt financing = 5,000 shares x $53 per share = $265,000

Amount of Debt to be financed = $265,000 x 30% = $79,500

Number of shars to be repurchased =79500 / 53 = 1500 shares

Total Number of shares outstanding after debt financing = 5,000 - 1,500 = 3,500 shares

Interest rate = 6%

Interest Payable annually = 79,500 x 6% = $4,770

Earnings before Interest and tax = $35,000

Earnings before tax = $35,000 - $4,770 = $30,230

Ignoring effect of  taxes :

Net Income = Earnings before tax= $30,230

Dividend per share = Net Income / Number of shares outstanding

Dividend per share = $30,230 / 3,500 = $8.637

Cash flow to fisher = Dividend per share x Number of shares owned by Fisher

= $8.637 x 200 = $1,727.4

So, Cash flow to fisher under Proposed capital structure = $1,727.4

If Dronalution converts, but Mr. Fisher prefers the all-equity capital structure, then  he can unlever his shares of stock by selling the existing shares of the current firm and to buy the new shares of another 100% equity financed firm.

Homemade leverage is a method of creating artificial leverage while invested in an unlevered company. In this the investor can take personal loans on Investment and from that amount he purchases investment in unlevered company.

By using the concept of homemade leverage Mr. Fisher can also take the benefit of leverage. So we can say that Dronalution's choice of capital structure is irrelevant.