Question

Test company is debating whether or not to convert its all-equity capital structure to one that is 35 percent debt. Currently there are 5,000 shares outstanding and the price per share is $49. EBIT is expected to remain at $43,600 per year forever. The interest rate on new debt is 7 percent and there are no taxes. a. Mr, Ram , a shareholder of the firm, owns 100 shares of stock. What is his cash flow under the current capital structure, assuming the firm has a dividend payout rate of 100 percent? b. What will Mr. Ram's cash flow be under the proposed capital structure of the firm? Assume that she keeps all 100 of her shares. c. Suppose the company does convert, but Mr. Ram prefers the current all-equity capital structure. Show how he could unlever his shares of stock to recreate the original capital structure. d. Using your answer to part (c), explain why the company's choice of capital structure is irrelevant

Answer 1

a) Cash flow for 100 shares= $ 872,

b) cash flow ofnthe firm = $ 1156.85,

c) Changed capital structure cash flows=$871.95

d) Changed capital stucture is irrelevant due to low cashflow.