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

Question

Star, Inc a prominent consumer products firm, is debating whether or not to convert its al-equity capital structure to one that is 40 percent debt. Currently there are 5,000 shares outstanding and the price per share is $65. EBIT is expected to remain at $37500 per year forever. The interest rate on new debt is 8 percent, and there are no taxes. Ms Brown a shareholder of the firm owns 100 shares of stock.

Suppose star does not 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.

Explanation / Answer

Income of Ms Brown

Before convertion

Income of Ms Brown

After convertion

Income of Ms Brown

Before convertion

Shares = 100 Earning Per Share = $7.5 Total Earnings (100 * 7.5) = $750 Shares (60%) = 60 Share capital (60 * 65) = $3900 Debt (40*65) = $2600

Income of Ms Brown

After convertion

Earning Per Shares (60 * 12.5) = $750 Interest on Debt (2600 * 8%) = $208 Total income = $958 Excess Income(958 - 750) = $208 Workings: Total Shares =5000 Total share capital (5000*65) =325000 Convert to Debt 40% = $130000 In shares =2000 Remaining Shares =3000 Total proft = $37500 Earning Per Share (before convert) = $7.5 (37000 / 5000) Earning per Share(after convertion) = $12.5 (37500 / 3000)

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