Question-7 (10 Points) OF Corporation (an all-equity financed firm) is contemplating about changing its capital structure. It plans to have 35% debt in the proposed capital structure. Currently, there are 7600 shares outstanding and the price per share is $55. EBIT is expected to remain at $36,000 per year forever. The interest rate on new debt is 8%, and there are no taxes. Which capital structure should Mr. ABC, a shareholder of the firm, prefer? He owns 100 shares of OF Corporation. Assume that dividend payout ratio is 100%. Question-8 (10 Points) The relationship between capital structure and firm value can be represented as follows: The X-axis represents the proportion of debt in capital structure and y-axis represents firm value. Briefly explain why the impact of capital structure on firm value is negative initially, then it turns positive and finally it becomes negative again.

OF corporation is an all equity financed firm right now.

Total capital of firm = number of shares outstanding * price per share = 7600 shares * $ 55 per share = $ 418,000.

EBIT of firm = $36,000

Dividend payout ratio is 100% meaning all the earnings are distributed as dividends to shareholders.

Therefore,

EPS (earning per share) = total earnings available to shareholders / number of shares outstanding

EPS = 36000 / 7600 = $4.7368 per share.  

So,

Earnings of Mr. ABC when firm is all equity financed firm = shares owned by Mr. ABC * EPS

= 100 * $4.7368 per share.

= $473.68

OF corporation is considering to include 35% debt in capital. [Here, we are assuming that debt capital borrowed will be used buy back shares, thus leaving total capital of firm same.]

Amount of debt in capital = debt percentage * total capital = 0.35 * 418,000 = $146,300

Interest payment on debt = debt capital * interest rate = 146,300 * 0.08 = $11,704

Equity capital remaining in structure = total capital - debt capital = 418,000 - 146,300 = $ 271,700

Number of shares outstanding now = equity capital remaining / price per share = 271,700 / 55 = 4940 shares.

Therefore,

EPS = (EBIT - interest) / number of shares outstanding = (36000 - 11704) / 4940 = $ 4.9182 per share

and,

Earnings of Mr. ABC with debt capital in structure becomes = 100 * $ 4.9182 = $491.82 (which is greater than earlier)

So, Mr. ABC is better off with a firm that has debt capital in structure. Because then Mr. ABC income is increased by $ 18.14 ($491.82 - $473.68).