My-Grain Limited is debating whether to set up with an all equity capital structure or one that is 60 per cent debt. An all-equity structure would have 12,000 shares outstanding and the price per share is $2.5. EBIT is expected to remain at $3000 per year forever. The interest rate on the debt is 9 per cent, and there are no taxes. The founding director, Mr Painful intends to have 2,000 shares.
a. What is Mr. Painful’s cash flow under the all equity capital structure?
b. What will Mr. Painful’s cash flow be with debt in the capital structure? Assume that he holds all 2,000 shares.
c. Suppose My- Grain uses debt but Mr. Painful prefers the all equity capital structure. Show how he could un-leverage his investment to recreate the capital structure?
d. Explain why the capital structure My-Grain chooses is irrelevant?