Desert Rose, Inc., a prominent consumer products firm, is debating whether to co
ID: 2790235 • 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 25 percent debt. Currently, there are 12,000 shares outstanding, and the price per share is $56. EBIT is expected to remain at $36,000 per year forever. The interest rate on new debt is 9 percent, and there are no taxes.
Allison, a shareholder of the firm, owns 100 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 100 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 25 percent debt. Currently, there are 12,000 shares outstanding, and the price per share is $56. EBIT is expected to remain at $36,000 per year forever. The interest rate on new debt is 9 percent, and there are no taxes.
Explanation / Answer
i)The EPS of the company= $36000/$12000
= $3
Since dividend payout is 100% ,the entire EPS will be distributed as dividend
Her cash flow from company holding 100 shares = $3*100 = $300
(ii)First determine the Eps under the proposed capital:
The market value of the firm =$56*12000
=$672000
The new debt to be raised = 0.25*672000
=$168,000
The no of shares to be repurchased = $168000/56
=3000 shares
The no of shares outstanding will be 9000 shares
the interest payment will be = $168000*.09 =$15120
The net income =$36000-15120
=$20880
The new eps will be $20880/9000 = $2.58
Share holder cash flow will be = $2.58*100 = 258
C)as per proposed capital structure ,the share holder should sell 25 shares and lend the proceeds at 9%
= 25*56*.09
=$126 (cash inflow)
dividend recieved for 75 shares = 75*2.58
= 193.5
total cash flow will be $126+$193.5 =$319.5