Question

Desert Rose, Inc., a prominent consumer products firm, is debating whether to convert its all-equity capital structure to one that is 20 percent debt. Currently, there are 16,000 shares outstanding, and the price per share is $83. EBIT is expected to remain at $86,400 per year forever. The interest rate on new debt is 6 percent, and there are no taxes.

  

a.	Allison, a shareholder of the firm, owns 300 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.)

  

Cash flow

$

  

b.	What will Allison’s cash flow be under the proposed capital structure of the firm? Assume she keeps all 300 of her shares. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

  

Cash flow

$

  

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.)

  

Total Cash flow

$

Answer 1

Solution:
a.	Cash flow	$1,620.00
Working Notes:
	Dividend payout ratio is 100% means pay all earned during the period.
	Total earnings during the period EBIT = 86,400
	Earnings per share = EBIT/No. of shares outstanding
	=86,400/16,000
	=$5.40 per share
	As payout ratio is 100% she will get $5.40 per share
	Total cash flow under the current capital structure = No. of shares x $5.40
		=300 x 5.40
		=$1,620.00
b.	Cash flow	$1,651.50
Working Notes:
	Current market value of the firm = No. of shares outstanding x Current price per share
		=16,000 x 83
		=$1,328,000
	As per new capital structure 20% is debt = 20% x 1328000 = $265,600
	No. of shares to be buy back= 20% x Market value of firm /current price per share
	=20% x $1,328,000/$83
	=3,200 shares
	No. of shares after buyback = Total outstanding - No. of shares buyback
	=16,000 -3,200
	=12,800
	Current EBIT	$86,400
	Less: Interest cost	15,936
	[Total debt x interest rate ]
	[265,600 x 6% ]
	Earning available for Equity shareholders	70,464
	New Earning per share = Earnings available to Equity shareholders / New no. of shares outstanding
		=$70,464/12,800
		=$5.505
	As payout ratio is 100% she will get $5.505 per share
	Total cash flow under the current capital structure = No. of shares x $5.505
		=300 x 5.505
		=$1,651.50
c.	Total Cash flow	$1,620.00
Working Notes:
	Allison unlevers her shares and re-creates the original capital structure.
	To unlever
	Then she sell her 20% shares buy the debt paying interest @6%
	Debt value = 20% x 300 x price per share
	=20% x 300 x $83
	=4,980
	Hence her Cash flow will be
	Dividend from firm on 80% share = 300 x 80% = 240 shares
	And interest on debt of 4,980
	EPS calculated in b. = $5.505
	Total cash flows = No. of shares left x EPS + Amount debt x interest rate
	= (240 x 5.505) + (4980 x 6%)
	=$1321.20 + 298.80
	=1,620	Which is the cash flow in a. which was her all equity cash flow.
Please feel free to ask if anything about above solution in comment section of the question.