Question

Star, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 40 percent debt. Currently there are 10,000 shares outstanding and the price per share is $60. EBIT is expected to remain at $60,000 per year forever. The interest rate on new debt is 8 percent, and there are no taxes.

A: Ms. Brown, a shareholder of the firm, owns 200 shares of stock. What is her cash flow under the current capital structure, assuming the firm has a dividend payout rate of 100 percent?

B: What will Ms. Brown's cash flow be under the proposed capital structure of the firm? Assume that she keeps all 200 of her shares.

C: Suppose the company does convert, but Ms. Brown prefers the current all-equity capital structure. Show how she could unlever her stocks to recreate the original capital structure.

Answer 1

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Part A
Net Income	60000
No of Shares outstanding	10000
Earning Per share	60000/10000	6
Dividend Per share	6*100%	6
Brown holding		200 Shares
Cash Flow for Brown	200 share*6 Per share dividend	1200
Part B
Firm will borrow 40% of Value for firm:
Value of Firm	10000 Shares*60 Per share price	600000
40% Debt	600000*40%	240000
Hence shares purchased	240000/60	4000 Shares
Balance shares outstanding	10000-4000	6000 Shares
EBIT	60000
Less: Interest 240000*8%	19200
Net Income	40800
No of Shares outstanding	6000
Earning per share 40800/6000	6.8 per share
Cash Flow for Brown	200 share*6.8 Per share dividend	1360
Part C
To Unlever:
She lends 40% of wealth
She sells 40% of her shares and lends at 8%
40% of 200 shares at 60	4800
Interest Income 4800*8%	384
Cash Flow	(120 Shares*6.8 per share)+Interest 384	1200