Question

Problem 1: 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

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