Question

Lydic 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 6,000 shares outstanding at a price per share of $90. EBIT is expected to remain constant at $75,000. The interest rate on new debt is 12 percent and there are no taxes.

a. Rebecca owns $36,000 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, e.g., 32.16.)

Shareholder cash flow       _____ $

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, e.g., 32.16.)

Shareholder cash flow _____ $

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 the nearest whole number, e.g., 32.)

Number of shares stockholder should sell _____?

Answer 1

a). Value of Company = No. of Shares x Share Price

= 6,000 x $90 = $540,000

Rebecca’s Cash flow = (Rebecca's Share / Value of Company) x EBIT

= ($36,000 / $540,000) x $75,000 = 0.0667 x $75,000 = $5,000

b). Shares repurchased = (Debt% x Value of Company) / Share Price

= (0.35 x $540,000) / $90 = $189,000 / $90 = 2,100 shares

Net Income = EBIT - [Interest% x (Debt% x Value of Company)]

= $75,000 - [0.12 x (0.35 x $540,000)]

= $75,000 - $22,680 = $52,320

EPS = Net Income / [No. of Shares - Shares Repurchased]

= $52,320 / (6,000 - 2,100) = $52,320 / 3,900 = $13.42

Shares Owned = Rebecca's Share / Share Price = $36,000 / $90 = 400 shares

Rebecca’s Cash flow = Shares Owned x EPS = 400 x $13.42 = $5,366.15

c). X = shares sold

[(Shares Owned - X) x EPS] + [Debt Cost x Share Price x X] = Rebecca's CF

[(400 - X) x $13.42] + [0.12 x $90 x X] = $5,000

$5,366.15 - $13.42X + $10.8X = $5,000

X = $366.15 / $2.62

X = 140 shares