Homemade Leverage Star, Inc., a prominent consumer products firm, is debating wh

Question

Homemade Leverage Star, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 35 percent debt. Currently thee are 6,000 shares outstanding and the price per share is $58. EBIT is 2 8. expected to remain at $39,600 per year forever. The interest rate on new debt is 7 percent, and there are no taxes. a. Ms. Brown, 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 percent? b. What will Ms. Brown's cash flow be under the proposed capital structure of the firm? Assume that she keeps all 100 of her shares. c. Suppose the company does convert, but Ms. Brown prefers the current all-equity capi- tal structure. Show how she could unlever her shares of stock to recreate the original capital structure. d. Using your answer to part (c), explain why the company's choice of capital structure is irrelevant.

Explanation / Answer

a.

Earnings per share : 39600/6000 shares = $6.6 per share

Dividend payout rate : 100%

Cash flow : $6.6 x 100 = $660

b.

The market value of the firm is 6000 shares x $58 = $348,000

Under proposed capital structure firm will raise new debt to

D = 0.35 ($348,000)

D = $121,800

Number of share repurchased will be

$121,800 /$58 = 2100

Company has make payment on new debt under new capital structure. the net income with interest will be

Net income = $39,600 – 0.07 ($121,800) = $31074

new capital structure will be $31074/(6000-2100)

                                                $31074/3900 = $7.96 per share.

The share holders will receive as dividend will be $7.96 per share x 100 shares = $796.

c.

1) To unlever star inc borrows – 35% of Ms brown wealth

2) Star buybacks –Ms brown sells 35% of her shares and lends at 7%

35% x 100 shares at $ 58 = $2030

Interest income $2030 x 7% = $142

Dividend received will be $7.96 x 65 shares = $518

Total cash flow = $518+$142 = $660

same as part A

d.To create their desired payoff, shareholder can create their own leverage or un lever the stock. so the capital structure is irrelevant here.

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