Conspicuous Consumption, Inc., a prominent consumer products firm, is debating w
ID: 2795736 • Letter: C
Question
Conspicuous Consumption, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 30 percent debt. Currently there are 9,000 shares outstanding and the price per share is $64. EBIT is expected to remain at $40,500 per year forever. The interest rate on new debt is 8.5 percent, and there are no taxes. a. Ms. Brown, 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 final answer to 2 decimal places (e.g., 32.16).) b. What will Ms. Brown’s cash flow be under the proposed capital structure of the firm? Assume that she keeps all 300 of her shares. (Do not round intermediate calculations and round your final answer to 2 decimal places (e.g., 32.16).) c. Assume that Ms. Brown unlevers her shares and re-creates the original capital structure. What is her cash flow now? (Do not round intermediate calculations and round your final answer to 2 decimal places (e.g., 32.16).)
Explanation / Answer
a) Dividend per share = EBIT / No. of shares = 40,500 / 9,000 = $4.50
Cash flows = 300 x 4.50 = $1,350.00
b) Debt = Share Price x No. of shares x Debt % = 64 x 9,000 x 30% = $172,800
No. of shares repurchased = 172,800 / 64 = 2,700
New outstanding shares = 9,000 - 2,700 = 6,300
Dividend per share = (EBIT - Interest) / No. of shares = (40,500 - 172,800 x 8.5%) / 6,300 = $4.097
Cash flows = 4.097 x 300 = $1,229.14
c) In order to recreate original capital structure, Ms Brown should sell 30% shares and lent that amount at 8.5%.
Amount Lent = 30% x 300 x 64 = $5,760
Remaining shares = 300 x (1 - 30%) = 210 shares
Cash flows = 210 x 4.097 + 5,760 x 8.5% = $1,350.00