Homemade Leverage Star plc, a prominent consumer products firm, is debating whether or not to convert its allequity capital structure to one that is 40 per cent debt.

Currently there are 2,000 shares outstanding, and the share price is £70. EBIT is expected to remain at £16,000 per year for ever. The interest rate on new debt is 8 per cent, and there are no taxes. Assume that the firm has a dividend payout rate of 100 per cent.

(a) Ms Brown, a shareholder of the firm, owns 100 shares of equity. What is her cash flow under the current capital structure?

(b) What will Ms Brown’s cash flow be under the proposed capital structure of the firm? Assume that she keeps all 100 of her shares.

(c) Suppose Star does convert, but Ms Brown prefers the current all-equity capital structure. Show how she could unlever her shares to recreate the original capital structure.

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