In: Finance
Star, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 50 percent debt. Currently there are 1,000 shares outstanding and the price per share is $65. EBIT is expected to remain at $37,500 per year forever. The interest rate on new debt is 8 percent, and there are no taxes.
a). EPS = NI / No. of Shares Outstanding = $37,500 / 1,000 = $37.50 per share
Payout = 100%
CF = $37.50 x 100 shares = $3,750
b). Current D/E: 100% Equity
D/E = 0; V = 1,000 × $65 = $65,000
Proposed D/E: 50% Debt; 50% Equity
D/E = 0.5/0.5 = 1.00
Under the proposed D/E, the firm has to:
1)Borrow 50% of V = $65,000 × 50% = $32,500
2)Buyback E at $65
New Shares Outstanding = 1,000 - ($32,500/$65) = 1,000 - 500 = 500
EPS = [EBIT - Interest] / New Shares Outstanding
= [$37,500 - ($32,500 x 0.08)] / 500 = $29,900 / 500 = $15.20 per share
Cash Flow = $15.2 x 100 shares = $1,520
c). To unlever:
1)Firm borrows: She lends 50% of her wealth
2)Firm buybacks: She sells 50% of her shares & lends at 8%
50% x 100 shares at $65 = 50 x $65 = $3,250
Interest Income = $3,250 x 0.08 = $260
CF = ($15.2 x 50 shares) + Interest
= $760 + $260 = $1,020
d). The question shows no matter how a firm alters its capital structure, shareholders can homemade / re-create the capital structure that they desire. Since they can create any capital structure they like, they won’t pay for a premium for a particular structure.Therefore, capital structure is irrelevant.