Suppose that you have 500 shares of Average Joes Gym stock in your portfolio. Av

Question

Suppose that you have 500 shares of Average Joes Gym stock in your portfolio. Average Joes 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. Average Joes 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 Average Joes stock must you sell to unlever your position if you can loan out funds at 8 percent interest?

Explanation / Answer

Initial investment = 500 shares*$40 = $20,000

Value of Joes Gym stock = [75,000 - ($1 million/$40)]*$40

= $2 million

Value of debt = $1 million

Thus total value of Joes Gym = $2 million+$1 million = $3 milion

Weight of equity in total value = 2 million/3 million = 2/3

My new stock position = 2/3*$20,000 = $13,333.33

This will transalte to $13,333.33/40 = 333.33 shares

Thus number of shares to be sold = 500 - 333.33 = 166.67 shares (or 168 shares rounded off)

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