Star, Inc. a prominent consumer products firm, is debating whether or not to con
ID: 2713344 • Letter: S
Question
Star, Inc. a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 35% debt. Currently there are 6,000 shares outstanding and the price per share is $58. EBIT is expected to remain at $33,000 per year, forever. The interest rate on new debt is 8%, and there are no taxes.
a) Ms. Brown, a shareholder in the firm, owns 100 shares of stock. What is her cash flow under the current capital structure assuming the firm has a dividend payout of 100%.
b) What will Ms. Brown’s cash flow be under the proposed capital structure of the firm? Assume she keeps all 100 of her shares.
c) Suppose Star does convert, but Ms. Brown prefers the current all-equity capital structure. Show how she could un-lever her shares of stock to recreate the original capital structure.
d) Using your answer in part (c), explain why Star’s choice of capital structure is irrelevant.
Explanation / Answer
Ans-
No of shares 6000
Price per share $58
Market value of share =6000*58=$348000
EBIT =$33000
Interest on debt 8%
Earning per share=33000/6000=5.5
Under 35% debt
No of shares (6000*65%)3900
Debt (348000*35%)$121800
Interest on debt (121800*8%)=$9744
EBT(33000-9744)=$23256
Earnings per share(23256/3900)5.96
a) Cash flow of Ms. Brown under current capital structure
No of share 100
Value of shares(58*100)=5800
Earning of shares(5.5*100)=550
Total cash flow (5800+550)$6350
b)Ms. Brown’s cash flow be under the proposed capital structure
Value of shares(58*100)=5800
Earning of shares(5.96*100)=596
Total cash flow (5800+596)$6396
c) If star does convert Ms. Brown cash flow is increase from $6350 to $6396
d)If star does convert Ms. Brown cash flow is increase from $6350 to $6396 so star's choice of capital structure is
irrelevant.
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