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 20 percent debt. Currently there are 11,000 shares outstanding and the price per share is $58. EBIT is expected to remain at $24,200 per year forever. The interest rate on new debt is 7.5 percent, and there are no taxes.

Ms. Brown, a shareholder of the firm, owns 200 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 answer to 2 decimal places, e.g., 32.16.)

What will Ms. Brown’s cash flow be under the proposed capital structure of the firm? Assume that she keeps all 200 of her shares. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

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 answer to 2 decimal places, e.g., 32.16.)

Star, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 20 percent debt. Currently there are 11,000 shares outstanding and the price per share is $58. EBIT is expected to remain at $24,200 per year forever. The interest rate on new debt is 7.5 percent, and there are no taxes.

Explanation / Answer

Current D/E: 100% Equity THEND/E = 0; Value =11,000 × $58 = $638,000 Proposed D/E: 20% Debt; 80% Equity Then D/E = 0.2/0.8 = 0.25 EBIT = 24,200 forever; Rd =7.5%; Taxes = 0% (a) Net Income=24200/11000=2.2 per share Payout 100% then Cash flow=200*2.2=$440 (b) Value of Shares 100%          6,38,000 Buyback of Shares By Debt 20%          1,27,600 Remaining Shares 80%          5,10,400 New Shares 80%                8,800 Debt Equity127600/510400 0.25 Net income Per share=(EBIT-Interest)/New Shares                                            =(24200-7.5%*127600)/8800                  1.66 Cash Flow=1.66*200 332 (c ) To Unlever Firm Borrows She lends 20% of her wealth Firrm Buybacks She sells 20% of her shares & lends at 7.5% 20%*200 Shares at 58=2,320 Cash Flow Interest Income=2320*7.5%=174 Cash Flow from Shares=1.66*200*80%=266 Total cash Flow =174+266=$440 (Same As part a above)

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