- Star, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 40 percent debt. Currently, there are 2,000 shares outstanding and the price per share is $70. EBIT is expected to remain at $16,000 per year forever. The interest rate on new debt is 8 percent, and there are no taxes.
- Knowles, 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?
- What will Ms. Knowles’ cash flow be under the proposed capital structure of the firm? Assume that she keeps all 100 of her shares.
- Suppose Star does convert, but Ms. Knowles prefers the current all-equity capital structure. Show how she could unlever her shares of stock to recreate the original capital structure.
- Using your answer to part (c), explain why Star’s choice of capital structure is irrelevant.
- The earnings per share are:
EPS = $16,000/2,000 shares
EPS = $8.00
So, the cash flow for the company is:
Cash flow = $8.00(100 shares)
Cash flow = $800
- To determine the cash flow to the shareholder, we need to determine the EPS of the firm under the proposed capital structure. The market value of the firm is:
V = $70(2,000)
V = $140,000
Under the proposed capital structure, the firm will raise new debt in the amount of:
D = 0.40($140,000)
D = $56,000
in debt. This means the number of shares repurchased will be:
Shares repurchased = $56,000/$70
Shares repurchased = 800
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 = $16,000 – .08($56,000)
NI = $11,520
This means the EPS under the new capital structure will be:
EPS = $11,520/1,200 shares
EPS = $9.60
Since all earnings are paid as dividends, the shareholder will receive:
Shareholder cash flow = $9.60(100 shares)
Shareholder cash flow = $960
- To replicate the proposed capital structure, the shareholder should sell 40 percent of their shares, or 40 shares, and lend the proceeds at 8 percent. The shareholder will have an interest cash flow of:
Interest cash flow = 40($70)(.08)
Interest cash flow = $224
The shareholder will receive dividend payments on the remaining 60 shares, so the dividends received will be:
Dividends received = $9.60(60 shares)
Dividends received = $576
The total cash flow for the shareholder under these assumptions will be:
Total cash flow = $224 + 576
Total cash flow = $800
This is the same cash flow we calculated in part a.
- The capital structure is irrelevant because shareholders can create their own leverage or unlever the stock to create the payoff they desire, regardless of the capital structure the firm actually chooses.
