Problem 13-8 Homemade Leverage [LO 1] FCOJ, Inc., a prominent consumer products
ID: 2755977 • Letter: P
Question
Problem 13-8 Homemade Leverage [LO 1] 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 5,000 shares outstanding and the price per share is $47. EBIT is expected to remain at $16,500 per year forever. The interest rate on new debt is 7 percent, and there are no taxes. Required: (a) Melanie, a shareholder of the firm, owns 280 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).) Shareholder cash flow $ (b) What will Melanie’s cash flow be under the proposed capital structure of the firm? Assume that she keeps all 280 of her shares. (Do not round intermediate calculations. Round your answer to 2 decimal places (e.g., 32.16).) Shareholder cash flow $ (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. Number of shares stockholder should sell
Explanation / Answer
a) Melanie's cash flow with the existing capital structure (all equity) and with 100% pay out
16500 * 280/5000 = $ 924
b) with 35% debt
Total Value of the firm = 5000 * 47 = $235000, Debt = 0.35 * 235000 = $82250
No of shares remaining = 152750/47 = 3250 shares
EBIT = 16500.00
Interest = 5757.50
Net Income 10742.50
Melaines share of Net Income (cash flow) =10742.5 * 280/3250 = $925.51
c) To recreate the original capital structure Melaine should sell 35% of her shares ie: sell 98 shares & lend it for 7%
Her proceeds as interest from lending would be 98*47*.07 = 322.42
Dividend on the remaining 182 shares = 10742.5*182/3250 = 601.58
Total cash flow for Melaine = 924.00 $
This is the same cash flow as in the first situation (at 'a' above)