Star, Inc., a prominent consumer products firm, is debating whether or not to co
ID: 2793796 • Letter: S
Question
Star, 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 14,000 shares outstanding and the price per share is $59. EBIT is expected to remain at $58,800 per year forever. The interest rate on new debt is 5.5 percent, and there are no taxes.
Ms. Brown, a shareholder of the firm, owns 200 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 Ms. Brown’s cash flow be under the proposed capital structure of the firm? Assume that she keeps all 200 of her shares. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
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 answer to 2 decimal places, e.g., 32.16.)
Star, 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 14,000 shares outstanding and the price per share is $59. EBIT is expected to remain at $58,800 per year forever. The interest rate on new debt is 5.5 percent, and there are no taxes.
Explanation / Answer
Answer)
Current D/ E = 100% Equity
D/E =0 , V = 14000 X 59 = 826,000
Proposed D/E =30% Debt and 70% Equity
D/E = 0.42857
EBIT = 58,800
Rd = 5.5%
Tc = 0%
Answer a) Net Income / Number of outstanding Share = 58800/ 14000 = 4.20
Payout = 100%
Cashflow = 4.2 x 200 = 840.
Answer b) Under the proposed D/E , the firm has to :
1) Borrow 30% of V = 30%* 826000 = 247,800
2) Buy back E at 59
New outstanding shares = 14000 - 247800/59 = 9800
After recapitalization , new D/E becomes
247800/ 59* 9800 = 0.429
Net Income / Outstanding shares = 58800- (247800*5.5%) / 9800 =4.61
Cashflow = 200 x 4.61 = 921.86
Answer c)
To unlever:1) Firm borrows-She lends 30% of her wealth
2) Firm buybacks-She sells 30% of her shares & lends at 5.5%
30% x 200 shares at 59 = 60 x 59 = 3540
Interest income = 3540 x 5.5% = 194.7
Cashflow = 4.61 x 70 =322.7 + 194.7 = 517.4
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