#5.) Desert Rose, Inc., a prominent consumer products firm, is debating whether

Question

#5.)

Desert Rose, Inc., a prominent consumer products firm, is debating whether to convert its all-equity capital structure to one that is 20 percent debt. Currently, there are 6,000 shares outstanding, and the price per share is $40. EBIT is expected to remain at $12,000 per year forever. The interest rate on new debt is 7 percent, and there are no taxes.

Allison, 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? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

What will Allison’s cash flow be under the proposed capital structure of the firm? Assume she keeps all 100 of her shares. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

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 answer to 2 decimal places, e.g., 32.16.)

Allison, 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? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Explanation / Answer

Part A

Here we first need to compute earnings per share

EPS = (EBIT – interest) x (1-tax rate)/ No. of shares

        = (12,000-0)x (1-0)/ 6000

        = 12000/6000

        = 2 per share.

Cash flow for Allison = EPS x no. of shares held

                                         = 2 x 100

                                         = 200

Part B

Value of the firm V= no. of shares x price per share

                                      = 6000 x 40

                                      = 240,000

Amount of debt issued = 240,000 x 20%

                                                = 48,000

Shares repurchased = amount of debt/ price per share

                                       = 48000/ 40

                                       = 1200 shares

EPS = (EBIT – interest)/ (shares outstanding)

       = (12,000 – 48,000 x0.07)/ (6,000 -1200)

       = 1.80per share

Cash flow for Allison = EPS x no. of shares held

                                         = 1.8 x 100

                                         = 180

Part C

This will bring her to the original situation and her cash flows will be brought back to 200 dollars

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