What is Capital Structure?

Q. 1 Mr. Fisher's Cash Flow Using the Existing Capital Structure. 

If there is a 100 percent dividend payout rate: 

EBIT= $35000

Cash Flow: $35000 x (200/5000) = $1400

Q. 2 Mr. Fisher’s Cash Flow Using the Proposed Capital Structure 

Dronalution, Inc. value = Number of shares x price/share

: $5000 x $53 = $265000

Debt rate 30 percent = 30/100 x $265000 = $79500

Shares to be repurchased = Debt Amount divide by Price/share

= $79500/ $53 = 1500 shares

Share remaining:

= 5000 – 1500 = 3500

Interest amount 6 percent = 6% of Debt amount

= 6/100 x $79500 = $4770

Net income = Interest subtracted from EBIT

= $35000 - $4770 = $30230

Dividend per share = Net income divided by no. of shares

= $30230/ 3500 = $8.6371

Mr. Fisher’s Cash Flow = 200 x $8.6371= $1727.42

Q. 3 

If Mr. Fisher desires to recreate the original capital structure, he can sell all of his shares back to the firm or purchase shares of a firm which has 100% equity (Sun et al. 2016)

Q. 4. Concept of Homemade Leverage 

Homemade leverage can result when a firm that has no leverage borrows money on investments as an individual loan (Stafford, 2017). The concept can be better explained using the Weighted Average Cost of Capital (WACC) (Frank & Shen, 2016).

All equity: EBIT/Market value

$35000/$265000 = 13.2 percent 

Levered can be calculated using:

= $265000 - $79500 = $185500

= $30230/$185500 x 100% = 16.3%

= (70/100) x (16.3/100) + (30/100) x (6/100)

= 13.2 % 

The company can employ homemade leverage by borrowing thirty percent of investment at a six percent rate from a financial institution and create an investment its shares. Hence, since the WACC for all the above are identical, the firm’s choice of capital structure has no significance.

References

Frank, M. Z., & Shen, T. (2016). Investment and the weighted average cost of capital. Journal of Financial Economics , 119 (2), 300-315.

Stafford, E. (2017). Replicating private equity with value investing, homemade leverage, and hold-to-maturity accounting. Homemade Leverage, and Hold-to-Maturity Accounting (May 20, 2017) .

Sun, J., Ding, L., Guo, J. M., & Li, Y. (2016). Ownership, capital structure and financing decision: Evidence from the UK. The British Accounting Review , 48 (4), 448-463.