Climax Motors Inc is currently all equity financed, but it is consider

Climax Motors Inc is currently all equity financed, but it is considering a leveraged capital structure, details of which are presented in the table below (under the column labeled ‘Proposed’).

Under the proposed capital structure, Climax will use all of the new debt to repurchase (and cancel) shares. Assume that taxes are zero. Assume that all of net income is paid out as a dividend in one year’s time. Assume that the debt is perpetual with an annual coupon rate of 6%. Wolfgang von Trips owns 25,000 shares. Under each capital structure, how much does Wolfgang receive in dividends at the end of each year? Assume that Wolfgang has the same number of shares under both structures.

Capital Structure Capital Structure
Current Proposed
EBIT $120,000 $120,000
Debt, D $0 $450,000
Cost of Debt, kd N/A 6%
Shares Outstanding 100,000 70,000
Stock Price $15.00 $15.00

A) Current: $30,000; Proposed: $30,000
B) Current: $30,000; Proposed: $23,250
C) Current: $30,000; Proposed: $42,857
D) Current: $30,000; Proposed: $33,214
E) Current: $30,000; Proposed: $27,684

ANSWER

D