Question

Conspicuous Consumption Inc., a prominent consumer products firm, is debating whether to convert its all-equity capital structure to one that is 35 percent debt. Currently, there are 8,000 shares outstanding and the price per share is $70. EBIT is expected to remain at $30,000 per year forever. The interest rate on new debt is 8 percent per year and there are no taxes.

a) Ms. Benson, a shareholder of the firm, owns 100 shares of the company. What is her cash flow under the current capital structure, assuming that the firm has a dividend payout ratio of 100 Percent?

b) What will Ms. Benson’s cash flow be under the proposed capital structure of the firm? Assume that she keeps all 100 of her shares.

c) Suppose that the company does convert, but Ms. Benson prefers the current all-equity capital structure. Show how she could unlever her shares of stock to recreate the original capital

Structure.

d) Using your answer in part (c), explain why the company’s choice of capital structure is irrelevant.

Answer 1

Part a)

As dividend payout is 100%, she will receive $3.75 per share as shown above. So for 100 shares, she will receive $375 every year.

Part b)

Under the new capital structure, Interest expense must be deducted from EBIT before EPS & dividend calculation as shown below:

So her cash flows will be 2.7538 * 100 = $275.38 per year.

Part c)

To recreate the all-equity structure on her own, she should take the following steps:

So her total cash flows will be $196+$179 = $375 which is the same as the original.

Part d)

We see that in the ideal situations the company's choice of capital structure is irrelevant because, under these ideal circumstances, each individual investor can create for herself whatever capital structure she desires by lending or borrowing money and adjusting the stock portfolio equivalently. This will hold true as long as the lending & borrowing rates & tax rates applicable to the company and individual investors are the same.