You currently own 600 shares of JKL, Inc. JKL is an all equity firm that has 75,

Question

You currently own 600 shares of JKL, Inc. JKL is an all equity firm that has 75,000 shares of stock outstanding at a market price of $40 a share. The company's earnings before interest and taxes are $140,000. JKL has decided to issue $1 million of debt at 8 percent interest. This debt will be used to repurchase shares of stock. How many shares of JKL stock must you sell to unlever your position if you can loan out funds at 8 percent interest? Ignore taxes. HINT: You unwind leverage by holding debt and equity in the levered company that is proportional to the levered company's capital structure. Start by finding the new capital structure (debt-equity ratio) if the firm issues the debt.

Explanation / Answer

Part 1 :

Every thing owned by JKL

interest = $1m ¥ 0.08 = $80,000

shares repurchased = 1million /40 = 25,000

shares with debt = 75,000 - 25,000 = 50,000

EPS, no debt = $140,000/75,000 = $1.866667

EPS, with debt = ($140,000 - $80,000)/50,000 = $1.20

value of stock = 50,000 ¥ $40 = $2million

value of debt = $1million

Part2 :

total value = $2m + $1m = $3million

weight stock = $2m/$3m = 2/3 = 0.667

weight debt = $1m/$3m = 1/3 = 0.33

Part3 :

OWN investment

initial investment = 600 ¥ $40 = $24,000

new stock position = 2/3($24,000) = $16,000

number of shares that are new= 350

Part 4 :

Number of shares sold = 600 - 350 = 250 shares

250 shares

250 shares

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