Desert Rose, Inc., a prominent consumer products firm, is debating whether to convert its all-equity capital structure

Question:

Desert Rose, Inc., a prominent consumer products firm, is debating whether to convert its all-equity capital structure to one that is 30 percent debt. Currently, there are 6,500 shares outstanding, and the price per share is $45. EBIT is expected to remain at $29,000 per year forever. The interest rate on new debt is 8 percent, and there are no taxes.

a. Allison, a shareholder of the firm, owns 100 shares of stock. What is her cash flow under the current capital structure, assuming the firm has a dividend payout rate of 100 percent?

b. What will Allison's cash flow be under the proposed capital structure of the firm? Assume she keeps all 100 of her shares.

c. Suppose the company does convert, but Allison prefers the current all-equity capital structure. Show how she could unlever her shares of stock to re-create the original capital structure.

d. Using your answer to part (c), explain why the company's choice of capital structure is irrelevant.

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