Answer:
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
