6885-15-8P AID: 63238 | 21/05/2020

Capital Structure refers to the amount of debt and equity of a certain company. The
Debt-Equity Ratio is an important factor as it affects the payoffs to the shareholders.
Financial Leverage may not affect the cost of capital but it has dramatic impact on the
investors confidence.

(a) In the Current Capital Structure:

16,000
Earnings per share = $
2,000
=$8
So, the cash flow for the company is

$ 8 ´ No. of shares = $ 8 ´ 100

= $ 800

Cash Flow generated as per All Equity Structure = $ 800

(b) To determine the cash flow to the shareholder under new proposed capital
structure, we will first find the market value of the firm.

The Market Value of the Firm = No. of shares ´ Price per share
=$ 2,000 ´ 70
=$ 1,40,000

As per the new proposed structure, debt will be 40% of the total value
i.e. $ 56,000 and equity will be $ 84,000
84,000
= 1,200 shares
Total no. of shares in this structure will be 70
EBIT = $ 16,000
Interest = 8% ´ Debt
= 8% ´ 56,000
= $ 4,480

EBT = EBIT – Interest

=$(16,000 – 4,840)
=$ 11,520

EBT
EPS =
No. of Shares
11,520
=$
1,200
=$ 9.6
Earnings per share in proposed Capital Structure is $ 9.6 per share.

So, the cash flow for the company as per the new structure will be
$ 9.6 ´ No. of shares = $ 9.6 ´ 100
= $ 960
Cash Flow generated as per New Capital Structure = $ 960

(c) To replicate the new proposed structure, the shareholder should sell 40% of her
shares i.e. 40 shares and lend the proceeds at 8%.

The shareholder will receive an interest cash flow of

Interest Cash Flow = No. of Shares ´ Share Price ´ Interest Rate

= 40 ´ 70 ´ 0.08
= $ 224

The shareholder will receive dividend payment on the remaining 70 shares which is:

Dividend Received = No. of shares ´ EPS

= 60 ´ 9.6
= $ 576

Cash Flow of the shareholder =Interest Cash Flow + Dividends Received

= $ 224 + 576
= $ 800
The total cash flow of the shareholder will be $ 800

(d) The capital structure is irrelevant because its shareholder’s choice on how to
create payoff – this is not dependent on the company’s capital structure.