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 30 percent debt. Currently there are 14,000 shares outstanding and the price per share is $63. EBIT is expected to remain at $77,000 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 250 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))

b. What will Ms. Browns cash flow be under the proposed capital structure of the firm? Assume that she keeps all 250 of her shares. (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

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.   The earnings per share are:

       EPS = $77,000/14,000 shares
       EPS = $5.50

       So, the cash flow for the company is:

       Cash flow = $5.50(250 shares)
       Cash flow = $1,375

b. 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 = $63(14,000)
       V = $882,000   
       
       Under the proposed capital structure, the firm will raise new debt in the amount of:
      
       D = 0.30($882,000)
       D = $264,600

       in debt. This means the number of shares repurchased will be:      

       Shares repurchased = $264,600/$63
       Shares repurchased = 4200

       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:

       NI = $77,000

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