Homemade Leverage [LO1] Mudpack, Inc., a prominent consumer products

fi rm, is debating whether to convert its all-equity capital structure to one that is 30

percent debt. Currently, there are 7,000 shares outstanding, and the price per share

is $55. EBIT is expected to remain at $27,000 per year forever. The interest rate on

new debt is 8 percent, and there are no taxes.

a. Allison, a shareholder of the fi rm, owns 100 shares of stock. What is her cash

fl ow under the current capital structure, assuming the fi rm has a dividend payout

rate of 100 percent?

b. What will Allisons cash fl ow be under the proposed capital structure of the

fi rm? 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 companys choice of capital

structure is irrelevant.