Desert Rose, Inc., a prominent consumer products firm, is debating whether to co
ID: 2655781 • Letter: D
Question
Desert Rose, Inc., a prominent consumer products firm, is debating whether to convert its all-equity capital structure to one that is 20 percent debt. Currently, there are 11,000 shares outstanding, and the price per share is $58. EBIT is expected to remain at $24,200 per year forever. The interest rate on new debt is 7.5 percent, and there are no taxes.
Allison, a shareholder of the firm, owns 200 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.)
What will Allison’s cash flow be under the proposed capital structure of the firm? Assume she keeps all 200 of her shares. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
Assume that Allison 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.)
Desert Rose, Inc., a prominent consumer products firm, is debating whether to convert its all-equity capital structure to one that is 20 percent debt. Currently, there are 11,000 shares outstanding, and the price per share is $58. EBIT is expected to remain at $24,200 per year forever. The interest rate on new debt is 7.5 percent, and there are no taxes.
Explanation / Answer
(a). Cash flow = $440
Explanation;
EBIT = $24200
Number of shares outstanding = 11000
Dividend payout rate = 100%
Thus per share dividend ($24200 / 11000) = $2.20
Thus cash flow will be (200 * $2.20) = $440
(b). Cash flow = $332.50
Explanation;
Total existing outstanding shares = 11000 shares
20 % debt proposed hence new outstanding shares will be;
(11000 * 0.80) = 8800 shares
EBIT is given = $24200
Interest on 20% debt will be (2200 * $58 * 0.075) = $9570
Thus net income after interest ($24200 - $9570) = $14630
Dividend payout rate = 100%
So per share dividend will be ($14630 / 8800) = $1.6625
Thus, cash flow (1.6625 * 200) = $332.50
(C). Cash flow = $440
Explanation;
20% of 200 share will be (200 * 0.20) = 40 shares
Price per share = $58
So total value ($58 * 40) = $2320
Interest inome on $2320 will be ($2320 * 0.075) = $174
Total cash flow will be = Dividend on outstanding shares + Interest income
Dividend on 160 shares (160 * $1.6625) + $174
= $266 + $174
Total cash flow = $440