Homemade leverage

Alberton Inc., an all-equity-financed equipment manufacturer, has announced that it will change its capital structure to one that will have 30 percent of debt, using the proceeds from the debt issue to buy back shares. The firm has one million shares outstanding and the share price is $60. Its operating margin, or earnings before interest and tax (EBIT), is expected to stay at its current level of $4 million for the foreseeable future. The interest rate on the debt that will be issued is 10 percent, and the firm does not pay any tax. Furthermore, Alberton has a dividend payout ratio of 100 percent, that is, all its earnings are distributed as dividends.

a. Mr. Robert owns 140,000 shares of stock. How much will Mr. Robert receive every year from Alberton under the current capital structure?

b. What will his cash flow be under the new capital structure, assuming that Mr. Robert keeps all of his shares?

c. Why will the cash flow received by Mr. Robert under the new capital structure be lower than under the current one? What can he do to avoid this cash loss and keep getting the same cash flow from the amount he invested in Alberton?