Staal Enterprises is considering a change from its current capital structure. St

Question

Staal Enterprises is considering a change from its current capital structure. Staal currently has an all-equity capital structure and is considering a capital structure with 35 percent debt. There are currently 6,000 shares outstanding at a price per share of $90. EBIT is expected to remain constant at $75,000. The interest rate on new debt is 12 percent and there are no taxes.

Rebecca owns $36,000 worth of stock in the company. If the firm has a 100 percent payout, what is her cash flow? (Do not round intermediate calculations. Round your answer to 2 decimal places (e.g., 32.16).)

What would her cash flow be under the new capital structure assuming that she keeps all of her shares? (Do not round intermediate calculations. Round your answer to 2 decimal places (e.g., 32.16).)

Suppose the company does convert to the new capital structure. Show how Rebecca can maintain her current cash flow.

Staal Enterprises is considering a change from its current capital structure. Staal currently has an all-equity capital structure and is considering a capital structure with 35 percent debt. There are currently 6,000 shares outstanding at a price per share of $90. EBIT is expected to remain constant at $75,000. The interest rate on new debt is 12 percent and there are no taxes.

Explanation / Answer

(a)

EBIT = $75,000

Number of shares = 6,000 shares

Earnings Per Share = EBIT/Number of shares = $75,000/6,000 = $12.5

Number of shares owned by Rebecca = $36,000/Price per share = $36,000/$90 = 400 shares

Cash flow for Rebecca = $12.5 X 400 shares = $5,000

(b)

Market value of firm = 6,000 shares X $90 = $540,000

Under new capital structure, the amount of debt = 35% X $540,000 = $189,000

Therefore, the number of shares repurchased = $189,000/$90 = 2,100 shares

Number of shares remaining = 6,000 - 2,100 = 3,900 shares

Interest payment = $189,000 X 12% = $22,680

Net Income = EBIT - Interest Payment = $75,000 - $22,680 = $52,320

New Earnings Per Share = Net Income/Number of shares remaining = $52,320/3,900 shares = $13.415

New Cash flow for Rebecca = 400 shares X $13.415 = $5,366.15

(c)

To maintain Rebecca's current cash flow, she should sell 35% of shares and lend the proceeds at 12%.

The number of shares she should sell = 35% shares = 400 shares X 35% = 140 shares

The interest she will get:

Interest cash flow = 140 X $90X 12% = $1,512

Remaining shares = 400 shares - 140 shares = 260 shares

Dividend cash flow= New Earnings per share X 260 shares = $13.42 X 260 shares = $3,488

Therefore, Total Cash flow for Rebecca = Interest cashflow + Dividend cashflow = $1,512 + $3,488 = $5,000 which is the same cash flow

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