Question

FCOJ, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 35 percent debt. Currently, there are 6,900 shares outstanding and the price per share is $59. EBIT is expected to remain at $26,220 per year forever. The interest rate on new debt is 10 percent, and there are no taxes.

Required:

(a) Melanie, a shareholder of the firm, owns 180 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. Round your answer to 2 decimal places (e.g., 32.16).)

(b) What will Melanie's cash flow be under the proposed capital structure of the firm? Assume that she keeps all 180 of her shares. (Do not round intermediate calculations. Round your answer to 2 decimal places (e.g., 32.16).)

(c) Suppose FCOJ does convert, but Melanie prefers the current all-equity capital structure. Show how she could unlever her shares of stock to recreate the original capital structure.

Answer 1

a. $684

b. $480.6

c. 63 shares

Step-by-step explanation:

a. The calculation of cash flow under the current capital structure is given below:-

Earning per share = Net income ÷ Shares

= $26,220 ÷ 6,900

= $3.8 per share

Cash flow = Earning per share × Stock shares

=$3.8 × 180 shares

= $684

b. The calculation of cash flow be under the proposed capital structure is given below:-

Value = $59 × 6,900

= $407,100

Under the capital structure suggested the company would collect new debt in the amount of:

Debt = 0.35 × $4071,00

= $142,485

Which means the amount of the repurchased shares will be:-

Shares repurchased = $142,485 ÷ $59

= $2,415

The Company will have to make an interest payment on the new debt under the new capital structure. The net income with the interest payment will be:-

Net income = $26,220 - 0.10 × $142,485

=$11,971.5

This means that the EPS will come under the new capital structure

Earning per share = $11,971.5 ÷ 4,485 shares

= $2.67 per share

Since all profits are paid out as dividends, the shareholder receives:-

Shareholder cash flow = Earning per share × Stock shares

= $2.67 × 180 shares

= $480.6

c. The shareholder would sell 35% of their shareholdings

= Shares × Debt percentage

= 180 × 35%

= 63 shares