Problem:
Ozone Depletion, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 30 percent debt. Currently, there are 800 shares outstanding and the price per share is $80. EBIT is expected to remain at $6,000 per year forever. The interest rate on new debt is 9 percent, and there are no taxes.
1) Rico, a shareholder of the firm, owns 100 shares of stock. What is his cash flow under the current capital structure, assuming the firm has a dividend payout rate of 100 percent?
2) What will Rico's cash flow be under the proposed capital structure of the firm? Assume that he keeps all 100 of his shares.
3) Suppose Ozone does convert, but Rico prefers the current all-equity capital structure. Show how he could unlever his shares of stock to recreate the original capital structure.
4) Using your answers to part (3), explain why Ozone's choice of capital structure is irrelevant.