Desert Rose, Inc., a prominent consumer products firm, is debating whether to co
ID: 2752311 • 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 14,000 shares outstanding, and the price per share is $59. EBIT is expected to remain at $58,800 per year forever. The interest rate on new debt is 5.5 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 30 percent debt. Currently, there are 14,000 shares outstanding, and the price per share is $59. EBIT is expected to remain at $58,800 per year forever. The interest rate on new debt is 5.5 percent, and there are no taxes.
Explanation / Answer
EPS per Share = EAT/ No of share (Since company has no debt , interest is 0. )
EPS per share = 4.2
Dividend payout Ratio = 100%
DPS = 4.2
Cash flow of Allision under current capital structure = Number of share * DPS
= 200 * 4.2 = $ 840
b) Proposed capital Structure :
Value = 14000 *59 = 826000
Debt = 30%
Debt value = 826000*30% = 247800$
Equity Value = 578200
EBIT = 58800
Interest = 247800*5.5% = 13629
EAT = 58800-13629 = 45171$
No of shares = 578200/ 59 = 9800
DPS = $45171/9800 = $4.61
Cash Flow under prposed structure = 200*4.61 = $922
c) To replicate the proposed capital structure, the shareholder should sell 30 percent of their shares, or 60 shares, and lend the proceeds at 5.5%percent. The shareholder will have an interest cash flow of:
Interest cash flow = 60($59)(.055)
Interest cash flow = $194.7
The shareholder will receive dividend payments on the remaining 140 shares, so the dividends received will be:
Dividends received = $4.61(140 shares)
Dividends received = $645.4
The total cash flow for the shareholder under these assumptions will be:
Total cash flow = $194.7 + 645.4
Total cash flow = $840
This is the same cash flow we calculated in part a.
EPS per Share = EAT/ No of share (Since company has no debt , interest is 0. )
EPS per share = 4.2
Dividend payout Ratio = 100%
DPS = 4.2
Cash flow of Allision under current capital structure = Number of share * DPS
= 200 * 4.2 = $ 840
Value = 14000 *59 = 826000
Debt = 30%
Debt value = 826000*30% = 247800$
Equity Value = 578200
EBIT = 58800
Interest = 247800*5.5% = 13629
EAT = 58800-13629 = 45171$
No of shares = 578200/ 59 = 9800
DPS = $45171/9800 = $4.61
Cash Flow under prposed structure = 200*4.61 = $922
Interest cash flow = 60($59)(.055)
Interest cash flow = $194.7
The shareholder will receive dividend payments on the remaining 140 shares, so the dividends received will be:
Dividends received = $4.61(140 shares)
Dividends received = $645.4
The total cash flow for the shareholder under these assumptions will be:
Total cash flow = $194.7 + 645.4
Total cash flow = $840
This is the same cash flow we calculated in part a.