Question

Conspicuous Consumption, 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 7,000 shares outstanding and the price per share is $44. EBIT is expecte to remain at $30,100 per year forever. The interest rate on new debt is 9 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? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Cash flow $1 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. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Cash flow c. Assume that Ms. Brown 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.) Cash flow %24

Answer 1

	a.
		Earning before interest and taxes	$30,100
		Interest	$0
		Taxes	$0
		Net Income	$30,100
		Number of shares outstanding	7000
		Earning per Share =30100/7000	$4.30
		Dividend per share (Payout 100%)	$4.30
		Cash Flow of Ms Brown	$645.00	(150*4.30)
	b	Cash Flow under Proposed Capital Structure
		Amount of debt =30%*7000*$44	$92,400
		Number of shares outstanding	4900	(7000*0.7)
		Earning before interest and taxes	$30,100
		Interest	$8,316	(92400*9%)
		Taxes	$0
		Net Income	$21,784
		Number of shares outstanding	4900
		Earning per Share =30100/7000	$4.45
		Dividend per share (Payout 100%)	$4.45
		Cash Flow of Ms Brown	$666.86	(150*4.45)
	c	RECREATE ORIGINAL CAPITAL STRUCTURE
		She Sells (150*30%)=45 shares	$1,980	(44*45)
		Invest the amount at 9% debt
		Interest Income =1980*9%	$178.20
		Dividend Income =(150-45)*4.45	$466.80
		Cash Flow of Ms Brown	$645.00	(178.20+466.80)