ABC Incorporation is thinking of converting its all-equity structure of capital to 40% debt, 60% common equity. Currently, the company’s 10,000 outstanding share are trading in the market at Rs 49 per share. Its EBIT is Rs 87,200 per year and is expected to remain same forever. If the company chooses to convert the all-equity stocks to debt, the interest rate on new debt would be 7%. The company is exempted to pay any tax due to its nature of business. Ms. Saima, owns 200 shares of the company. What would be her total earnings under existing capital structure assuming that firm pays all its income as dividends? Under the proposed new capital structure, what earnings Saima can expect? Assume that she still holds all 200 shares. (Note that if the company chooses the new capital structure, it needs to borrow debt and repurchase some of its existing shares with that debt to make the proposed capital structure of 40% debt and 60% common equity). Assume that company decided to convert its existing capital structure to the new one, but Saima do prefer the existing all equity capital structure. Show how could she recreate the old (all equity) capital structure by un-levering her shares. Focusing on part (c), can you explain why the firm’s capital structure choice is irrelevant?

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter15: Dividend Policy

Section: Chapter Questions

Problem 4P

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ABC Incorporation is thinking of converting its all-equity structure of capital to 40% debt, 60% common equity. Currently, the company’s 10,000 outstanding share are trading in the market at Rs 49 per share. Its EBIT is Rs 87,200 per year and is expected to remain same forever. If the company chooses to convert the all-equity stocks to debt, the interest rate on new debt would be 7%. The company is exempted to pay any tax due to its nature of business.

Ms. Saima, owns 200 shares of the company. What would be her total earnings under existing capital structure assuming that firm pays all its income as dividends?
Under the proposed new capital structure, what earnings Saima can expect? Assume that she still holds all 200 shares. (Note that if the company chooses the new capital structure, it needs to borrow debt and repurchase some of its existing shares with that debt to make the proposed capital structure of 40% debt and 60% common equity).
Assume that company decided to convert its existing capital structure to the new one, but Saima do prefer the existing all equity capital structure. Show how could she recreate the old (all equity) capital structure by un-levering her shares.
Focusing on part (c), can you explain why the firm’s capital structure choice is irrelevant?

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