UNLEV has an expected perpetual EBIT = $4,000. The unlevered cost of capital = 15% and there are 20,000 shares of stock outstanding. The firm is considering issuing $8,800 in new par bonds to add financial leverage to the firm. The proceeds of the debt issue will be used to repurchase equity. The cost of debt = 10% and the tax rate = 34%. There are no flotation costs.

Assume a stockholder owns 1,000 shares of UNLEV before the restructuring. Also assume UNLEV's debt/equity ratio will be 0.493 after the restructuring. How could the stockholder use homemade leverage to unlever her investment in the firm after the restructuring? Assume there are no taxes.
A) The stockholder should borrow $1,330 and buy 1,000 more shares of UNLEV.
B) The stockholder should borrow $2,660 and buy 1,000 more shares of UNLEV.
C) The stockholder should borrow $1,330 and buy 2,000 more shares of UNLEV.
D) The stockholder should lend $443 and sell 333 shares of UNLEV.
E) The stockholder should lend $1,337 and sell 667 shares of UNLEV.

Question

UNLEV has an expected perpetual EBIT = $4,000. The unlevered cost of capital = 15% and there are 20,000 shares of stock outstanding. The firm is considering issuing $8,800 in new par bonds to add financial leverage to the firm. The proceeds of the debt issue will be used to repurchase equity. The cost of debt = 10% and the tax rate = 34%. There are no flotation costs.

Assume a stockholder owns 1,000 shares of UNLEV before the restructuring. Also assume UNLEV's debt/equity ratio will be 0.493 after the restructuring. How could the stockholder use homemade leverage to unlever her investment in the firm after the restructuring? Assume there are no taxes.
A) The stockholder should borrow $1,330 and buy 1,000 more shares of UNLEV.
B) The stockholder should borrow $2,660 and buy 1,000 more shares of UNLEV.
C) The stockholder should borrow $1,330 and buy 2,000 more shares of UNLEV.
D) The stockholder should lend $443 and sell 333 shares of UNLEV.
E) The stockholder should lend $1,337 and sell 667 shares of UNLEV.

Quizplus · Accepted Answer

To recreate the unlevered position after the restructuring, the stockholder needs to adjust their exposure to the firm's equity to offset the firm's new leverage. This can be done by lending (investing) a portion of their investment equivalent to the proportion of debt the firm is taking on and adjusting their equity position accordingly. Given the debt/equity ratio of 0.493 after restructuring, the stockholder should aim to have a similar proportion of their investment in a risk-free asset (lending out money) and adjust their equity holdings to mirror the firm's new capital structure. Lending $443 and selling 333 shares is a way to adjust the investment to match the effect of the firm's new leverage without actually borrowing money.

UNLEV Has an Expected Perpetual EBIT = $4,000