Desert Rose, Inc., a prominent consumer products firm, is debating whether to co
ID: 2728575 • 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 30 percent debt. Currently, there are 20,000 shares outstanding, and the price per share is $57. EBIT is expected to remain at $62,000 per year forever. The interest rate on new debt is 4 percent, and there are no taxes. a. Allison, a shareholder of the firm, owns 300 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.) Cash flow $ b. What will Allison’s cash flow be under the proposed capital structure of the firm? Assume she keeps all 300 of her shares. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Cash flow $ c. 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.) Total Cash flow $
Explanation / Answer
a. The earnings per share are:
EPS = $62,000/20,000 shares
EPS = $3.10
Dividend payout ratio is 100%, therefore whole $3.10 is paid to shareholders.
Cash flow = $3.10 * 300 shares = $930
b. 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:
Value of company = Price per share * No. of shares outstaniding = $57*20,000 = $1,140,000
Under the proposed capital structure, the firm will raise new debt in the amount of:
Value of debt = $1,140,000 * 30% = $342,000
This means the number of shares repurchased will be:
Shares repurchased = $342,000/$57 = 6,000 shares
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:
Interest payment = $342,000*4% = $13,680
Net income = $62,000 - $13,680 = $48,320
EPS = $48,320/14,000 shares = $3.45
Since all earnings are paid as dividends, the shareholder will receive $2.42 per share.
Allison’s cash flow = $3.45*300 shares = $1,035
c. To replicate the proposed capital structure, the shareholder should sell 30 percent of their shares, or 90 shares, and lend the proceeds at 4 percent. The shareholder will have an interest cash flow of:
Interest cash flow =90 shares * $57* 4% = $205.20
The shareholder will receive dividend payments on the remaining 210 shares, so the dividends received will be:
Dividends received = $3.45*210 shares = $724.50
Allison’s cash flow = $205.20+$724.50 = $929.70
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.