FCOJ, Inc., a prominent consumer products firm, is debating whether or not to co
ID: 2763172 • Letter: F
Question
FCOJ, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 30 percent debt. Currently, there are 7,900 shares outstanding and the price per share is $64. EBIT is expected to remain at $24,016 per year forever. The interest rate on new debt is 9 percent, and there are no taxes.
Melanie, a shareholder of the firm, owns 240 shares of stock. What is her cash flow under the current capital structure, assuming the firm has a dividend payout rate of 100 percent?
What will Melanie’s cash flow be under the proposed capital structure of the firm? Assume that she keeps all 240 of her shares.
Suppose FCOJ does convert, but Melanie prefers the current all-equity capital structure. Show how she could unlever her shares of stock to recreate the original capital structure.
FCOJ, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 30 percent debt. Currently, there are 7,900 shares outstanding and the price per share is $64. EBIT is expected to remain at $24,016 per year forever. The interest rate on new debt is 9 percent, and there are no taxes.
Required: (a)Melanie, a shareholder of the firm, owns 240 shares of stock. What is her cash flow under the current capital structure, assuming the firm has a dividend payout rate of 100 percent?
(b)What will Melanie’s cash flow be under the proposed capital structure of the firm? Assume that she keeps all 240 of her shares.
(c)Suppose FCOJ does convert, but Melanie prefers the current all-equity capital structure. Show how she could unlever her shares of stock to recreate the original capital structure.
Explanation / Answer
a. Calculation of Earnings Per Share (EPS) and cash flow
EPS = $24,016/7,900 shares = $3.4 per share
No. of shares held by Malanie = 240 shares
So, cashflow = 240 x $3.4 = $729.6
b. Cash Flow under new capital structure
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 = $64 x 7,900 shares
V = $505,600
Under the proposed capital structure, the firm will raise new debt(D) in the amount of:
D = 0.30 x $505,600
D = $151,680
This means the number of shares repurchased will be:
Shares repurchased = $151,680/$64
Shares repurchased = 2,370
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:
Net Income = $24,016 – 0.09x$151,680
Net Income = $10,364.8
This means the EPS under the new capital structure will be:
EPS = $10364.8/5,530 shares
EPS = $1.87
Since all earnings are paid as dividends, the shareholder will receive $1.87 for all the 240 shares:
Shareholder cash flow = $1.87 x 240 shares
Shareholder cash flow = $449.83
C.To recreate original capital structure
In order to do this, the shareholder should sell 30 percent of their shares, or 72 shares, and lend the proceeds at 9 percent.
He will receive interest amount = 72*64*9% = $414.72
He will receive dividend for the balance 168 shares = 168x$1.87 = $314.88
Total cash flow = $414.72 + $314.88 = $729.6
This is the same cash flow we calculated in part a.
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