Homemade Leverage: Star, Inc., a prominent consumer products firm, is debating w

Question

Homemade Leverage: 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?

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?

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.

4. Using your answer to part (3), explain why Star’s choice of capital structure is irrelevant.

Explanation / Answer

No of shares in Star Inc. ( all- equity) 1000

EBIT =$ 37500

earning per share=37500/1000=$ 37.50

Ms Brown has 100 shares and at 100% dividend payout ratio her cash flow would be =no of shares held * earing per share

100*37.50=$ 3750

Under capital restructure =i.e at 8% debt (50% equity+50% Debt) 1000 shares @ $ 65 each=1000*65=65000

the intrest that will be paid on the debt =$ 2600 (65000/2=32500@ 8% intrest)

so the new EBIT =$ 37500-$ 2600=$34900

under new proposal EPS =34900/500=$ 69.80(assumed that with debt amount realised 500 shares)

Ms.Brown will receive (100% payout ratio) 100*69.80=$ 6980

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