Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity, according to M&M Proposition 1, what are the interest payments that you receive after you undo the restructuring, and what are your total cash flows? (Do not round intermediate calculations. Round the final answer to two decimal places.)
A) $1.58 and $12.38
B) $23.55 and $75
C) $1.125 and $12.38
D) None of the above

Question

Quizplus · Accepted Answer

According to M&M Proposition 1, the change in the capital structure does not affect the total value of the firm or the total cash flows. Therefore, we can use the current values to calculate the interest payments and total cash flows after the restructuring is undone.

Total cash flows = $150
Equity portion = 60%
Debt portion = 40%

New equity = 0.60 / 0.75 = 0.8
New debt = 0.40 / 0.75 = 0.5333

After the restructuring, your ownership percentage of the equity portion would be:
(0.10 * 0.75) / (0.10 * 0.75 + 0.10 * 0.25 * 0.5333) = 0.1972 or 19.72%

Your interest payments would be:
0.1972 * 0.5333 * $150 * 0.07 = $1.58

Your total cash flows would be:
0.1972 * $150 + $1.58 = $12.38