Star, Inc., a prominent consumer products firm, is debating whether or not to co

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 percent debt. Currently there are 6,000 shares outstanding and the price per share is $58. EBIT is expected to remain at $39,600 per year forever. The interest rate on new debt is 7 percent, and there are no taxes.

a. 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?

b. What will Ms. Browns cash flow be under the proposed capital structure of the firm? Assume that she keeps all 100 of her shares.

c. Suppose the company 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.

d. using your answer to part (c), explain why the company's choice of capital structure is irrelevant.

solving Step-by-step will be greatly appreciated. thanks in advance

Explanation / Answer

Current Capital Struction - 100% equity

Debt - Equity Ratio = Debt / Equity = 0

Total firm value = 6000 x $58 = $348,000

a) Since, current their is no taxes and no interest payment, EBIT will be the earnings available to shareholders'.

EPS = Earnings available to equity shareholders' / no. of shares = $39,600 / 6000 shares = $6.6 per share

And, payout ratio is 100% -

Cash flow for Ms. Brown = $6.6 per share x 100% x 100 shares = $660

b) To change the capital structure, the firm will -

1. Borrow 35% of the total firm value = $348,000 x 35% = $121,800

2. Repurchase shares worth $121,800 at the current market price = $121,800 / $58 per share = 2100 shares

No. shares after recapitalisation = 6000 - 2100 = 3900

New Earnings available to equity shareholders = EBIT - Interest = $39,600 - 7% x $121,800 = $31,074

New EPS = $31,074 / 3900 = $7.96769230769 or $7.97

New Cash flow for Ms. Brown = $7.97 x 100 = $797

c) To unlever her shares, she will Lend 35% of her wealth. So, when firm repurchases / buybacks, she sells 35% of her shares and lends @7% -

Amount received when shares sold @58 = 100 x 35% x $58= $2,030

Now, she will lend this amount and earn interest on the same -

Interest Income = $2,030 x 7% = $142.10

Cash Flow = Dividend on shares held + interest Income

Or, Cash flow = 65 x $7.97 + $142.10 = $660.15 (0.15 difference due to rounding off)

d) The question shows no matter how a firm alters its capital structure, shareholders can homemade / re-create the capital structure that they desire. Since they can create any capital structure they like, they won’t pay for a premium for a particular structure. Therefore, capital structure is irrelevant.

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