Conspicuous Consumption, Inc., a prominent consumer products firm, is debating w
ID: 2801380 • 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 20 percent debt. Currently there are 16,000 shares outstanding and the price per share is $83. EBIT is expected to remain at $86,400 per year forever. The interest rate on new debt is 6 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 answer to 2 decimal places, e.g., 32.16.).Cash flow $
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 answer to 2 decimal places, e.g., 32.16.) Cash flow $
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 answer to 2 decimal places, e.g., 32.16.) Cash flow $
Explanation / Answer
a. EBIT of the firm is $86400 per year
Initially it is an all equity firm so total number of shares is 16000 and since Debt is not there hence the net profit of the firm would be;
EBIT $86400
Less Interest 0
Profit before Tax $86400
Less Tax (No Taxes) 0
Profit after Tax $86400
So EPS = Profit after Tax/ Number of Shares Outstanding
Or, EPS = $86400/16000 = $5.4/- per share
Again the Dividend Payout Ratio = Dividend Price per Share/ Earnings Price per Share
Or, 1 = DPS/ 5.4
Or, DPS = 5.4
So total cash flow of Ms. Brown Would be = Number of Shares * DPS
Or, total cash flow of Ms. Brown would be = $5.4*300 = $1620
b. Now if the company shifts to a new capital structure then we need to segregate the initial capital structure
Initial capital structure = Market Price Per share * Number of shares outstanding
Or, Initial capital structure = $83*16000 = $1328, 000
Share of Debt will be 20% (as mentioned) = $1328, 000*0.20 = $265,600
So, share of Equity will be 80% = 1328000*0.80 = $1062400
Number of shares will be = $1062400/ Market Price= $1062400/83 = 12800
Again, EBIT $86400
Less; Interest (265600*6%) $15936
Profit before Tax $70464
Less Tax (No Taxes) 0
Profit after Tax $70464
So EPS = Profit after Tax/ Number of Shares Outstanding
Or, EPS = $70464/12800 = $5.51/- per share
Again the Dividend Payout Ratio = Dividend Price per Share/ Earnings Price per Share
Or, 1 = DPS/ 5.51 (since payout ratio is 100%)
Or, DPS = 5.51
So total cash flow of Ms. Brown Would be = Number of Shares * DPS
Or, total cash flow of Ms. Brown would be = $5.51*300 = $1653
c. Now if Ms. Brown unlevers her share and re-creates the original capital structure then total number of shares owned by her would be;
(300/16000*12800= 240 shares) (Applying the unitary method) (80% of share capital)
Again the DPS will remain the same at $5.51
So total cash flow of Ms. Brown Would be = Number of Shares * DPS
Or, total cash flow of Ms. Brown would be = $5.51*240 = $1322.40