Question

Company E is debating whether to convert its all-equity capital structure to one that is 40% debt. Currently, there are 8,000 shares outstanding, and the price per share is $55. EBIT is expected to remain at $32,000 per year forever. The interest rate on new debt is 8%, and there are no taxes. (a) XYZ, 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%? (b) What will XYZ’s cash flow be under the proposed capital structure of the firm? Assume he keeps all 100 of his shares. (c) Suppose the company does convert, but XYZ prefers the current all-equity capital structure. Show how he could unlever his shares of stock to recreate the original structure. (d) Using your answer to part (c), explain why the company’s choice of capital structure is irrelevant.

Answer 1

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ke - Microsoft Excel (Product Activation Failed) File Home Insert Page Layout Formulas Data Review View Add-Ins - 2x % Cut Σ AutoSum : A Calibri -11AA = = = Dr Wrap Text General Ea Copy Fill Paste B - I D U A Merge & Center $ - % 8.9 Conditional Format Sort & Cell Find & Format Painter Insert Delete Format Formatting as Table Styles 2 Clear Filter Select Clipboard Font Alignment Number Styles Cells Editing PV1153 for PT PU PV PW PX PY PZ QA Formula Bar QC Q D QE OF QG QH QI 1136 1137 EBIT 32000 1138 TOTAL NO OF SHARES 8000 1139 VALUE OF THE FIRM = 8000 X 55 = 440000 1140 1141 AS HE OWNS 100 SHARES 1142 CASH FLOW = 400.00 32000*(100/5800) 1143 1144 TOTAL VALUE OF FIRM = 440000 1145 DEBT = 40% = 176000 1146 EQUITY = 264000 1147 NO OF SHARES = 264000/55 4800 1148 1149 EBIT 32000 1150 INTEREST 14080 [176000 x 8%] 1151 EARNINGS FOR SHAREHOLDERS 17920 1152 1153 CASHFLOW 373.33 [17920 X 100/4800] 1154 1155 when company issues 40% debt 1156 He will sell 40% of his shares & lend same at 8% interest M CoNvexity DGM betaport future INDEX INTL CAP BUD LEASING PV, FV, ANNUITY DIR right clean YIELD bond portfolio cap stru WACC RESI ex div DIV POLICY NAME DIV YIELDI Rea ferences: CF135 BOU 120% 1 + 2. 9 * ENG 23-11-2019 H 1a e 9 .

ke - Microsoft Excel (Product Activation Failed) File Home Insert Page Layout Formulas Data Review View Add-Ins - 2x * Cut Σ AutoSum : A Calibri -11AA = = = Dr Wrap Text General E Copy Fill Paste B B- I A U Merge & Center - Sort & $ -% Find & Format Painter . Formatting as Table Styles 2 Clear Filter Select Clipboard Font Alignment Number Styles Cells Editing PV1174 fx _ PT PU PVPW PX PY PZ QA QBQC QD QE OF QGQH Q5 1155 when company issues 40% debt 1156 He will sell 40% of his shares & lend same at 8% interest 1157 100 x 40% = 40 shares will be sold 1158 remaining shares = 60 1159 so sale value of shares = 40 X 55 = 2200 1160 INTEREST INCOME AT 8% 176 [2200 X 8%] 1161 1162 1163 EBIT 32000 1164 INTEREST 14080 [176000 x 8%] 1165 EARNINGS FOR SHAREHOLDERS 17920 1166 1167 CASHFLOW (dividend) 224.00 1168 CASHFLOW (interest) 176.00 [2200 X 8%] 1169 CASHFLOW 400.00 1170 1171 AS HE EARNS SAME CASH FLOW UNDER ALL EQUITY STUCTURE AS WELL AS LEVERED STRUCTURE 1172 CAPITAL STRUCTURE IS NOT RELEVANT : CHECK ANSWER OF (a) AND (c) = 400 = SAME 1173 1174 1175 M CoNvexity DGM betaport future INDEX INTL CAP BUD LEASING PV, FV, ANNUITY DIR right clean YIELD bond portfolio cap stru WACC RESI ex div DIV POLICY NAME DIV YIELDI Rea ferences: CF135 BOJ 120% 0 2. 9 * ENG 23-11-2019 H