Star, Inc. a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 35% debt. Currently there are 6,000 shares outstanding and the price per share is $58. EBIT is expected to remain at $33,000 per year, forever. The interest rate on new debt is 8%, and there are no taxes.
a) Ms. Brown, a shareholder in the firm, owns 100 shares of stock. What is her cash flow under the current capital structure assuming the firm has a dividend payout of 100%.
b) What will Ms. Brown’s cash flow be under the proposed capital structure of the firm? Assume she keeps all 100 of her shares.
c) Suppose Star does convert, but Ms. Brown prefers the current all-equity capital structure. Show how she could un-lever her shares of stock to recreate the original capital structure.
d) Using your answer in part (c), explain why Star’s choice of capital structure is irrelevant.