Question

In: Finance

Star, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity...

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.

  1. Ms. Brown, a shareholder of the firm, owns 100 shares of stock. What is her cash flow under the current capital structure, assuming the firm has a dividend payout rate of 100 percent? (4 points)
  2. What will Ms. Brown’s cash flow be under the proposed capital structure of the firm? Assume that she keeps all 100 of her shares? (6 points)
  3. Suppose Star does convert, but Ms. Brown prefers the current all-equity capital structure. Show how she could unlever her shares of stock to recreate the original capital structure. (6 points)
  4. Using your answer to part (c), explain why Star’s choice of capital structure is irrelevant. (4 points)

Solutions

Expert Solution

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.


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