Answer:
a) $780
b) $865.5
c) 174.15 + 605.85 = $780
Explanation:
a) The first part of the question is to determine Ms. Brown's cash flow under Star Inc's current capital structure- Dividend payout rate of 100 percent
First we know that the Earnings Before Interest and Tax is $26,000
However, at this instance which is the current capital structure, there is no tax and no debt
hence Earnings Per share = $26,000 / 5000 shares = $5.2
So, Ms. Brown's cash flow = 150 shares x $5.2 = $780
b) Ms. Brown's cash flow under the proposed debt and equity structure. 150 shares kept
Step 1 - calculate the total capital = $86 x 5000 shares = $430,000
30% of this now (0.3 x 430,000) goes into debt = $129,000. This debt is also used to buy shares as follows
= $129,000/ $86 = 1,500 shares (bought with debt)
Step 2: The shares bought with equity now = 5,000- 1,500 =3,500 shares
Also, the debt has a rate of 4.5%, meaning the interest rate on the $129,000 borrowed = 0.045 x 129,000= $5,805
Step 3: Star Inc's net income = Earnings before interest and tax - interest - tax
= $26,000 - $5,805-0 = $20,195
The New earnings per share = $20,195 / the new number of equity shares
= $20, 195 / 3500 = 5.77
Ms. Brown's cash flow under the new structure = 150 shares x $5.77 = $865.5
c) Ms. Brown's cash flow if she recreates the original capital structure and unlevers her shares
The meaning of this is that Ms. Brown decides to sell 30% of her shares and then lends it at 4.5% just like the company did.
30 of 150 = 45 shares x $86 = $3,780
Interest to be made if she lends it at 4.5% = $3,780 x 0.045 = $174.15
Also, Since she only sold 45 shares, she is still entitled to dividend on the remaining (150-45) = 105 shares
Using the new Earnings Per share under the Levered business
Ms. Brown's dividend = $5.77 x 105 shares = $605.85
It means her entire cash flow will be
The interest received on the levered 30% + The dividend received on the remaining 70% equity
= $174.15 + $605.85
= $780 which is the same as the initial or the old structure in question A above.
