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 17,000 shares outstanding and the price per share is $47. EBIT is expected to remain at $39,100 per year forever. The interest rate on new debt is 6.5 percent, and there are no taxes. Ms. Brown, a shareholder of the firm, owns 150 shares of stock. What is her cash flow under the current capital structure, assuming the firm has a dividend payout rate of 100 percent? What will Ms. Brown’s cash flow be under the proposed capital structure of the firm? Assume that she keeps all 150 of her shares. Assume that Ms. Brown unlevers her shares and re-creates the original capital structure. What is her cash flow now?

Explanation:

1)  The earnings per share are:

EPS = $39,100/17,000 shares

EPS = $2.30

Cash flow for the company is:

Cash flow = $2.30 X 150 shares

Cash flow = $345

2) Need to determine the EPS of the firm under the proposed capital structure. The market value of the firm is:

MV = $47*17,000  = $799,000

Under the proposed capital structure, the firm will raise new debt in the amount of  D = 0.20*$799,000 = $159,800 in debt. The number of shares repurchased will be:

Shares repurchased = $159,800/$47  = 3400

Under the new capital structure, the company will have to make an interest payment on the new debt. The net income with the interest payment will be:

NI = $39,100 – 0.065*$159,800  = $39100-10,387= $28,713

EPS under the new capital structure will be:

EPS = $28,713/13,600 shares  = $2.11

Shareholder cash flow = $2.11*150 shares  = $316.5

3)  In this case, capital structure is irrelevant because shareholders can create their own leverage or unlever the stock to create different capital structures. This has no connection with the capital structure that firm chooses.

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