16.8 Desert Rose ,Inc., a prominent consumer products firm ,is debating whether

Question

16.8 Desert Rose ,Inc., a prominent consumer products firm ,is debating whether to convert its all -equity capital structure to one that is 30 percent debt. Currently, there are 6,500 shares outstanding , and the price per share is $45. EBIT is expected to remain at $29,000 per year forever. The interst rate on new debt is 8% and no taxes.

a) Allison, a shareholder of the firm, owns 100 shares of stock. What is her cash flow under the current capital structure, assuming th firm has a dividend payout rate 100 %?

B)What will Allison's cash flow be under the proposed capital structure of the firm? Assume she keeps all 100 of her shares.

C) Suppose the company does convert, but Allison prefers the current all-equity capital structure. Show how she could unlever her shares of stock to re-create the original structure.

D) Using your answere to part(c) , explain why the company's choice of capitl structure is irrelevant.

Please give me the answer and do step by step. Thank you

Explanation / Answer

a. Allison's cash flow under the current capital structure- All Equity EBIT= 29000 Dividend 100%= 29000 No.of shares o/s= 29000/6500 Value of Firm= 6500*45= 292500 Per Share dividend 4.46153846 Cashflow to Allison ie.Dividend for 100 shares= 446.154 b. Allison's cash flow under the proposed capital structure- 30% Debt& 70% Equity As Per MM Proposition I, When there are no taxes, Value of unlevered firm= Value of Levered firm So, Total Value of firm 292500 Debt 30% 87750 Equity 70% 204750 No.of Equity shares = 204750/45= 4550 EBIT 29000 Less: Interest @8%*87750 7020 Earnings available to Equity 21980 (As 100% Dividend pay-out) Cashflow to Allison ie.Dividend for 100 shares= 21980/4550*100 483.0769 c)She could unlever her shares of stock to re-create the original structure She sholud sell 30%(ie. 30) of her shares to create debt & receive interest @ 8% Then, Cash flow in the form of: Interest 30sh*45*8% 108 Dividends on the bal. 70 shares 21980/4550*70 338.154 Total cash flow 446.154 d) As can be seen from answers to a & c (Same) - Company's choice of capital structure is irrelevant- and the shareholder can decide to lever/unlever-ie. Decide whether to hold only equity or a mix of equity & debt , on his own and can decide their cash flows/income independently.

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