Question

FCOJ, 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 5,000 shares outstanding, and the price per share is $86. EBIT is expected to remain at $26,000 per year forever. The interest rate on new debt is 4.5 percent, and there are no taxes.

a. Ms. Brown, a shareholder of the firm, owns 150 shares of stock. What is her cash flow under the current capital structure, assuming the firm has a dividend payout rate of 100 percent?

b. What will Ms. Brown’s cash flow be under the proposed capital structure of the firm? Assume that she keeps all 150 of her shares.

c. Assume that Ms. Brown unlevers her shares and re-creates the original capital structure. What is her cash flow now?

Answer 1

The cash flow for Ms. Brown under different capital structures can be calculated using the earnings per share (EPS) and the number of shares she owns. In the current capital structure, her cash flow is determined by the dividend payout rate and the number of shares she owns. Under the proposed capital structure, the introduction of debt will affect the earnings available to shareholders, resulting in a different cash flow. If Ms. Brown unlevers her shares, her cash flow will revert to the original capital structure.

Step-by-step explanation:

a. Ms. Brown's cash flow under the current capital structure can be calculated by multiplying the number of shares she owns by the dividend per share. With a dividend payout rate of 100 percent, the dividend per share is the same as the earnings per share (EPS). We can calculate the EPS by dividing the EBIT (earnings before interest and taxes) by the number of shares outstanding:

EPS = EBIT / Number of shares outstanding

Then, we can calculate Ms. Brown's cash flow:

Cash flow = EPS × Number of shares Ms. Brown owns

b. Under the proposed capital structure, the firm is introducing debt, which will reduce the earnings available to shareholders. The new EPS can be calculated by subtracting the interest expense (which can be calculated as the debt-to-equity ratio multiplied by the interest rate) from the EBIT, and then dividing by the new number of shares outstanding (which is the current number of shares plus the additional shares issued for debt). We can then calculate Ms. Brown's cash flow using the new EPS:

Cash flow = New EPS × Number of shares Ms. Brown owns

c. To unlever her shares, Ms. Brown can sell a portion of her shares to repurchase the firm's debt. The remaining shares will have the same EPS as before, so her cash flow will be the same as in part a.

Answer 2

a) EBIT = 26000

Since in the 1st case, there is no debt and no tax, net income = EBIT

So EPS = 26000 / 5000 = $5.2

Since the entire earnings are distributed as dividends, Ms. Brown cash flow = 150 * 5.2 = $780`

b) 30% of capital is converted to debt

Total capital = 5000 * 86 = 430,000

30% of which is 129000 is converted into debt, and assume that company has repurchased shares with this debt.

So number of shares bought = 129000 / 86 = 15000

New number of shares = 5000 - 1500 = 3500

Interest payment = 129000 * 4.5% = 5805

So Net income = EBIT - interest - tax = 26000 - 5805 - 0 = 20195

EPS = 20195 / 3500 = 5.77

So cash flow for Ms. Brown = 150 * 5.77 = 865.5

c)

To replicate the proposed capital structure, the shareholder should sell 30 percent of their shares, or 45 shares, and lend the proceeds at 4.5 percent. The shareholder will have an interest cash flow of:

Interest cash flow = 45($86)(.045)

Interest cash flow = $174.15

The shareholder will receive dividend payments on the remaining 1.5 shares, so the dividends received will be:

Dividends received = $5.77(1 shares)

Dividends received = $576

The total cash flow for the shareholder under these assumptions will be:

Total cash flow = $174.15 + 605.85

Total cash flow = $780

This is the same cash flow we calculated in part a