Abco is an all equity firm with 32,000 shares of stock outstanding at a market price of $40 a share. The company's earnings before interest and taxes are $92,000. Abco has decided to add leverage to its financial operations by issuing $220,000 of debt at a 9% rate of interest. The debt will be used to repurchase shares of stock. You own 600 shares of Abco stock. You also lend out funds at a 9% rate of interest. How many shares of Abco stock must you sell to offset the leverage that Abco is assuming? Assume you lend out all of the funds you receive from the sale of stock.

Question

Quizplus · Accepted Answer

To offset the leverage, you need to sell shares equivalent to the debt per share. The debt per share is $220,000 / 32,000 = $6.875. You own 600 shares, so you need to sell 600 * $6.875 / $40 = 103 shares.

Abco Is an All Equity Firm with 32,000 Shares of Stock