Q9. Zombie Inc., a prominent consumer products firm, is debating whether or not

Question

Q9. Zombie Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 40% debt. Currently, there are 1,000 shares outstanding and the price per share is $70. EBIT is expected to remain at $7,000 per year forever. The interest rate on new debt is 7% and there are no taxes.

a) a, Ms. Spears, 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%?

b) b, What will Ms. Spear’s cash flow be under the proposed capital structure of the firm? Assuming that she keeps all 100 of her shares.

c) c, Suppose Zombie does convert, but Ms. Spears prefers the current all-equity capital structure. Show how she could unlever her shares of stocks to recreate the original capital structure.

Explanation / Answer

a) 100 shares; 100% payout => $700 cash flow

b) For new system, EBIT = 7000

Eaerning after interest = 7000 - 0.07 * 0.4 * 7000 = 7000 - 196 = 6804

for 1000 shares, divident = 6804/1000 = 6.804

cash flow = $680.4

c) for 700 cash flow woth 6.804 divident, total shares = 700/6.804 = 102.9

so, she should buy 2.8 shares more

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