Conspicuous Consumption, Inc., a prominent consumer products firm, is debating w

Question

Conspicuous Consumption, 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 5,000 shares outstanding and the price per share is $86. EBIT is expected to remain at $26,000 per year forever. The interest rate on new debt is 4.5 percent, and there are no taxes. a. Ms. Brown, a shareholder of the firm, owns 150 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 final answer to 2 decimal places (e.g., 32.16).) Cash flow $ b. What will Ms. Brown’s cash flow be under the proposed capital structure of the firm? Assume that she keeps all 150 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 Ms. Brown 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).)

Explanation / Answer

a) Cash Flow = No. of shares x Dividend per share = 150 x 26,000 / 5,000 = $780

b) Debt = % Value x No. of shares x Share Price = 30% x 86 x 5,000 = $129,000

New outstanding shares = 5,000 - 129,000 / 86 = 3,500

Cash Flows = No. of shares x (EBIT - Interest) / Outstanding shares

= 150 x (26,000 - 129,000 x 4.5%) / 3,500 = $865.5

c) In to re-create the original capital structure, Brown must sell 30% shares and lend the proceeds at 4.5%

Shares sold = 30% x 150 = 45

Proceeds = 45 x 86 = $3,870

New Cash Flows = (150 - 45) x (26,000 - 129,000 x 4.5%) / 3,500 + 3,870 x 4.5% = $780

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