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 25 percent debt. Currently there are 12,000 shares outstanding and the price per share is $56. EBIT is expected to remain at $36,000 per year forever. The interest rate on new debt is 9 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? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) b. 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. (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

Answer:

a. Cash flows under current capital structure (All equity)

EBIT   = $36000

Number of shares =12000

Cash flow per share = 36000 /12000 = $3

Hence cash flow forms. Brown = 100 Shares * $3 = $300

b. Cash flows under proposed capital structure (25% Debt)

Current capital = 12000 shares * $56 = $672000

Debt to be taken = 672000 * 15% =168000

Equity = 672000

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