13- Desert Rose, Inc., a prominent consumer products firm, is debating whether t
ID: 2784353 • Letter: 1
Question
13-
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 8,000 shares outstanding, and the price per share is $41. EBIT is expected to remain at $32,000 per year forever. The interest rate on new debt is 5 percent, and there are no taxes.
Allison, a shareholder of the firm, owns 300 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 Allison’s cash flow be under the proposed capital structure of the firm? Assume she keeps all 300 of her shares. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
Assume that Allison 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.)
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 8,000 shares outstanding, and the price per share is $41. EBIT is expected to remain at $32,000 per year forever. The interest rate on new debt is 5 percent, and there are no taxes.
Explanation / Answer
a.
Dividend per share = EBIT/ Total shares outstanding = 32000/ 8000 = $4
Alison’s cash flow= $4 * Number of shares held
= $4* 300 = $1200
b. Value of the firm = 8000*$41 =328000
Debt= 30%*328000 = 98400
Shares repurchased = 98400/ 41 = 2400
Balance shares outstanding = 8000-2400 = 5600
Dividend distributed = EBIT- Interest = 32000-5%*98400
= 27080
EPS= 27080/ 5600 = $4.836
Alison’s cash flow = 4.836* 300 = $1450
c. Shares sold by Allison = 30%*300 = 90
Value of shares = 90*41 = 3690
Interest income = 3690*5% = 184.5
Dividend on shares = (300-90)* 4.836 = 1015.56
Total cash flow= Interest income + dividend = $1200.06 which is the same as before.
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