Question

Mudpack, Inc., a prominent consumer products firm, is debating whether to convert its all-equity capital structure to one that is 30 percent debt. Currently, there are 18,000 shares outstanding, and the price per share is $49. EBIT is expected to remain at $63,000 per year forever. The interest rate on new debt is 10 percent, and there are no taxes. a. Allison, a shareholder of the firm, owns 250 shares of stock. What is her cash flow under the current capital structure, assuming the firm has a dividend payout rate of 100 percent? (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 250 of her shares. (Do not round intermediate calculations and round your final 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 final answer to 2 decimal places. (e.g., 32.16))

Total Cash flow

Answer 1

a) Computation of cash flow under the current capital structure:

= Expected EBIT / Number of shares outstanding *Shares held

=$63,000 / 18,000 * 250 = $875

b)Computation of Cash flow under proposed capital structure:

Value of Debt=Market Capitalization×Debt Percentage

=(18,000 shares*$49) * 30%

=$882,000*30%= $264,600

Number of Share Repurchased:

=Value of Debt / Current stock Price=$264,600/ $49 =5,400 shares

Number of Share Outstanding:

=Number of Share Outstanding−Share Repurchased

=18,000 - 5,400 = 12,600 shares

Net income per share:

=Expected EBIT - Interest / Number of shares outstanding

=$63,000-(2,64,000*10%) / 12,600

=2.90

Cash flow =2.90*250 = $725

Cash flow = $725

c) Recreation of original capital structure:

Number of shares to be sold= Current Share Holding * Debt percentage

=250 shares * 30% = 75 shares

75 shares has to be sold and lend 30% at the rate of 10%

Cash flow:

Dividend= 250(1-0.30)*2.90= $507.5

Interest = (250*49) *0.30*0.10 =$367.50

=$507.5 + $367.50= $875