Star, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 30 percent debt. Currently there are 5,000 shares outstanding and the price per share is $86. EBIT is expected to remain at $26,000 per year forever. The interest rate on new debt is 4.5 percent, and there are no taxes.

a. 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?

b. 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.

c. Assume that Ms. Brown unlevers her shares and re-creates the original capital structure. What is her cash flow now?

a) $780

b) $865.5

c) 174.15 + 605.85 = $780

Explanation:

a) The first part of the question is to determine Ms. Brown's cash flow under Star Inc's current capital structure- Dividend payout rate of 100 percent

First we know that the Earnings Before Interest and Tax is $26,000

However, at this instance which is the current capital structure, there is no tax and no debt

hence Earnings Per share = $26,000 / 5000 shares = $5.2

So, Ms. Brown's cash flow = 150 shares x $5.2 = $780

b) Ms. Brown's cash flow under the proposed debt and equity structure. 150 shares kept

Step 1 - calculate the total capital = $86 x 5000 shares = $430,000

30% of this now (0.3 x 430,000) goes into debt = $129,000. This debt is also used to buy shares as follows

= $129,000/ $86 = 1,500 shares (bought with debt)

Step 2: The shares bought with equity now = 5,000- 1,500 =3,500 shares

Also, the debt has a rate of 4.5%, meaning the interest rate on the $129,000 borrowed = 0.045 x 129,000= $5,805

Step 3: Star Inc's net income = Earnings before interest and tax - interest - tax

= $26,000 - $5,805-0 = $20,195

The New earnings per share = $20,195 / the new number of equity shares

= $20, 195 / 3500 = 5.77

Ms. Brown's cash flow under the new structure = 150 shares x $5.77 = $865.5

c) Ms. Brown's cash flow if she recreates the original capital structure and unlevers her shares

The meaning of this is that Ms. Brown decides to sell 30% of her shares and then lends it at 4.5% just like the company did.

30 of 150 = 45 shares x $86 = $3,780

Interest to be made if she lends it at 4.5% = $3,780 x 0.045 = $174.15

Also,  Since she only sold 45 shares, she is still entitled to dividend on the remaining (150-45) = 105 shares

Using the new Earnings Per share under the Levered business

Ms. Brown's dividend = $5.77 x 105 shares = $605.85

It means her entire cash flow will be

The interest received on the levered 30% + The dividend received on the remaining 70% equity

= $174.15 + $605.85

= $780  which is the same as the initial or the old structure in question A above.

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