Mudpack, Inc., a prominent consumer products firm, is debating whether to conver

Question

Mudpack, Inc., a prominent consumer products firm, is debating whether to convert its all-equity capital structure to one that is 25 percent debt. Currently, there are 15,000 shares outstanding, and the price per share is $38. EBIT is expected to remain at $48,000 per year forever. The interest rate on new debt is 9.5 percent, and there are no taxes.

a. Allison, a shareholder of the firm, owns 200 shares of stock. What is her cash flow under the current capital structure, assuming the firm has a dividend payout rate of 100 percent? (Round your answer to 2 decimal places. (e.g., 32.16)) Cash flow $

b. What will Allison’s cash flow be under the proposed capital structure of the firm? Assume she keeps all 200 of her shares. (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) Cash flow $

c. Assume that Allison unlevers her shares and re-creates the original capital structure. What is her cash flow now? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) Total Cash flow $

Explanation / Answer

Answer

a. The earnings per share are:

         EPS = $48000 /15,000 shares

         EPS = $3.2

         So, the cash flow for the company is:

         Cash flow = $3.2(200 shares)

         Cash flow = $6400

b.    To determine the cash flow to the shareholder, we need to determine the EPS of the firm under the proposed capital structure. The market value of the firm is:

         V = $38(15000)

         V = $570,000  

         Under the proposed capital structure, the firm will raise new debt in the amount of:

         D = 0.25($570,000)

         D = $142,500

         in debt. This means the number of shares repurchased will be:                       

         Shares repurchased = $142,500/$38

         Shares repurchased = 3750

         Under the new capital structure, the company will have to make an interest payment on the new debt. The net income with the interest payment will be:

         NI = $48,000 – .095($142,500)

         NI = $34462

         This means the EPS under the new capital structure will be:

         EPS = $34462/11,250 shares

         EPS = $3.06   

         Since all earnings are paid as dividends, the shareholder will receive:

         Shareholder cash flow = $3.06(200 shares)

         Shareholder cash flow = $612

c.    To replicate the proposed capital structure, the shareholder should sell 25 percent of their shares, or 25 shares, and lend the proceeds at 9.5 percent. The shareholder will have an interest cash flow of:

         Interest cash flow = 25($38)(.095)

         Interest cash flow = $90.25

         The shareholder will receive dividend payments on the remaining 75 shares, so the dividends received will be:

         Dividends received = $3.06(75 shares)

         Dividends received = $229.75  

         The total cash flow for the shareholder under these assumptions will be:

         Total cash flow = $90.25+229.5

         Total cash flow = $319.75

         This is the same cash flow we calculated in part a.

The capital structure is irrelevant because shareholders can create their own leverage or unlever the stock to create the payoff they desire, regardless of the capital structure the firm actually chooses.

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