Question

FCOJ Inc., a prominent consumer products firm is debating whether to convert its all-equity capital structure to one that is 35 percent debt. Currently there are 5.000 shares outstanding and the price per share is $49. EBIT is expected to remain at $43.600 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 capital 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.

Answer 1

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07:15 C W ENG 99+ 30-07-2020 27 Х x Z33 . S T U V W X Y Z AA AB AC AD AE - 10 11 a NOW MS.BROWN OWNS 100 SHARES 12 13 CASH FLOW TO MS.BROWN = 872.00 [43600*(100/5000) ] [EBIT X (SHARES OWNED BY MS. BROWN/TOTAL SHARES] 14 15 16 17 b TOTAL VALUE OF FIRM = 5000 X 49 = 245000 18 DEBT VALUE = 35% OF FIRM VALUE 85750 159250 19 20 21 22 23 VALUE OF EQUITY = 245000 - 85750 NO OF SHARES LEFT = 159250/49 = 3250 EBIT 43600 LESS 24 25 26 INTEREST ON 85750 AT 7% EARNINGS FOR SHAREHOLDERS 6002.5 37597.5 CASH FLOW TO MS.BROWN = 1156.85 [37597.5 X 100/3250] 27 28 с 29 30 WHEN COMPANY ISSUES DEBT, SHE HAS TO SELL DEBT EXACTLY OF THE SAME PERCENTAGE SHE WILL SELL 35% OF HER EQUITY AND LEND THAT MONEY AT 7% RATE 31 32 SHE WILL SELL = 100 X 35% = 35 SHARES 33 SALE VALUE OF SHARES AT 49 = 1715 [35 X 49] ASSET L UTILITY LOAN EAIR OLIVER NOMINAL SBUX excel pv fv DAUTEN reinvest Sheet6 Sheet11 CASH FLOW royal +

07:16 C W ENG 99+ 30-07-2020 27 Х 251 x . S T U V w Х Y Z АА AB AC AD AE - 28 29 с WHEN COMPANY ISSUES DEBT, SHE HAS TO SELL DEBT EXACTLY OF THE SAME PERCENTAGE SHE WILL SELL 35% OF HER EQUITY AND LEND THAT MONEY AT 7% RATE 30 31 32 SHE WILL SELL = 100 X 35% = 35 SHARES SALE VALUE OF SHARES AT 49 = 33 1715 [35 X 49] 34 35 INTEREST INCOME FOR MS.BROWN 120.05 [1715 X 7%] 36 NOW WE WILL CALCULATE CASH FLOW 37 38 39 EBIT 43600 LESS INTEREST ON 85750 AT 7% EARNINGS FOR SHAREHOLDERS 6002.5 37597.5 40 41 42 CASH FLOW IN FORM OF DIVIDEND CASH FLOW IN FORM OF INTEREST 43 44 751.95 (37597.5 X 65/3250] 120.05 [1715 X 7%] 872.00 CASH FLOW TO MS.BROWN = 45 46 d 47 NOW SEE CASH FLOW TO MS.BROWN UNDER CASE a AND CASE C: BOTH ARE SAME = 872 WHEN TAXES ARE ABSENT, INVESTOR CAN CREATE A SITUATION WHERE BY HE CAN HAVE SAME LEVEL OF CASH FLOW WHICH IS KNOWN AS HOMEMADE LEVERAGE, SO CAPITAL STRUCTURE IS IRRELEVANT 48 49 50 51 ASSET L UTILITY LOAN EAIR OLIVER NOMINAL SBUX excel pv fv DAUTEN reinvest Sheet6 Sheet11 CASH FLOW royal +