Suppose that Lil John Industries’ equity is currently selling for $28 per share

Question

Suppose that Lil John Industries’ equity is currently selling for $28 per share and that 2.1 million shares are outstanding. The firm also has 51,000 bonds outstanding, which are selling at 102 percent of par. Assume Lil John was considering an active change to its capital structure so that the firm would have a (D/E) of 1.5. Which type of security (stocks or bonds) would it need to sell to accomplish this?

Sell bonds and buy back stock OR Sell stock and buy back bonds? What's the selling amount?

Explanation / Answer

Capital structure weights

E / (E +D) = 2100000 * $ 28 / (2100000* $ 28 +51000 *1000*1.02) =.531

D /(E+D) = ( 51000 *1000*1.02) / (2100000 * $ 28 +51000 *1000*1.02) =0.469

So current D/E of 0.469/0.531 = 0.8846

As he was considering increasing debt ratio to 1.5

So thery have to change debt ratio to 1.5/2.5 =0.6

Which would require (0.6 - 0.469) × [($2,100,000 × $28) + (51000 × $1,000 × 1.02)] = 14517420 of new debt and using the proceeds to repurchase stock

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