Answer to Question #302713 in Finance for jeff

Question

Ford Motor, an auto manufacturer, is debating whether to convert its all-equity capital structure to one that is 40 percent debt. Currently there are 8,000 shares outstanding and the price per share is $60. EBIT is expected to remain at $64,000 per year forever. The interest rate on new debt is 5.5 percent, and there are no taxes.

a. If the firm has a 100% dividend payout rate, what is the cash flow under the current capital structure to David who owns 160 shares of Ford Motor stock?

b. Assume David keeps all 160 of his shares. What will his cash flow be under the proposed capital structure of the firm?

c. Suppose David prefers the current all-equity capital structure, but Ford Motor does convert. Show how he could unlever his shares of stock to recreate the original capital structure.

d. Using your answer to part (c), is Ford Motor’s choice of capital structure relevant? Explain. 

Answer 1

a. 

The calculation of cash flow under the current structure of capital is:

Calculation :

Formula snip:

$1,280.00 = shareholder cash flow under the current structure of capital.

 

b.

The calculation of cash flow under the proposed capital structure is:

Calculation :

Formula snip :

$1,840.00 = shareholder cash flow under current capital.

 

c.

The calculation to un lever the shares is:

Calculation :

Formula snip:

The recreated capital structure has a cash flow of $1,280.00

 

d. The cash flows derived by the leverage method and equity method is the same, so the structure of capital is irrelevant.