Question

Desert Rose, Inc., a prominent consumer products firm, is debating whetherto convert its all-equity capital structure to one that is 30 percent debt. Currently, there are 6,500 sharesoutstanding, and the price per share is $45. EBIT is expected to remain at $29,000 per year forever. Theinterest rate on new debt is 8 percent, and there are no taxes.a) Allison, 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 100%?B) What will Allison's cash flow be under the proposed capital structure of the firm? Assume she keeps all 100 of her shares.C) Suppose the company does convert, but Allison prefers the current all-equity capital structure. Show how she could unlever her shares of stock to re-create the original structure.D) Using your answere to part(c), explain why the company's choice of capitl structure is irrelevant. Show work and explain.

Answer 1

A. $450

B. $480

C. $540

D. The choice of capitl structure is irrelevant because the amount of $480 is the payoff amount based on the proposed capital structure with 30% debt, which indicate that investors cannot make use of home leverage to help create the capital structure as well as the payoffs they like.

Step-by-step explanation:

a) Calculation to determine her cash flow under the current capital structure

First step is to calculate the earnings per share

EPS = $29,000 / 6,500 shares

EPS = $4.5

Now let calculate the cash flow under the current capital structure

Cash flow = $4.5*(100 shares)

Cash flow = $450

Therefore her cash flow under the current capital structure will be $450

b) Calculation to determine What will be the cash flow be under the proposed capital structure of the firm

First step is to calculate the earnings per share

First step is to calculate the MV of the firm

MV of the firm= $45(6,500)

MV of the firm= $292,500

Second step is to calculate the Debt

Debt = .30 x ($292,500)

Debt= $87,750

Third step is to calculate the Interest

Interest =8% x $87,750

Interest = $7,020

Fourth step is to calculate the repurchase shares

Repurchase shares =$87,750 / $45

Repurchase shares= 1,950

Fifth step is to calculate the Shrout new

Shrout new =6,500 - 1,950

Shrout new=4,550

Therefore, under the new capital structure,

EPS = (EBIT - Interest) / shares outstanding new

EPS = ($29,000 -$7,020) / 4,550shares

EPS =$21,980/4,550 shares

EPS =4.8

The shareholder will receive = $4.8*(100 shares) = $480

Therefore What will be the cash flow be under the proposed capital structure of the firm is $480

c) Calculation to Show how she could unlever her shares of stock to re-create the original structure.

Now she owns a total of 200 shares

Her payoff =[ (100 shares+100 shares) x $4.5 ]- [8% x $(100 shares x $45)]

Her payoff =(200shares×$4.5)-(8%×$4,500)

Her payoff =$900-$360

Her payoff= $540

Therefore Based on the above Calculation Allison did not successfully replicate the payoffs (b) under the proposed capital structure

d).Based on the above Calculation the choice of capitl structure is irrelevant because the amount of $480 is the payoff amount based on the proposed capital structure with 30% debt, which indicate that investors cannot make use of home leverage to help create the capital structure as well as the payoffs they like.