An investor owns 500 shares of stock in a Montreal ﬁrm with a debt/equity ratio = 1.0. The investor prefers a debt/equity ratio = 1.5. If the stock price is $2 per share, what should the investor do?

Question

Quizplus · Accepted Answer

The current debt-to-equity ratio is 1.0, which means that for every dollar of equity, the company has one dollar of debt. The investor wants a ratio of 1.5, which means that for every dollar of equity, the company should have $1.50 of debt.

In order to increase the debt-to-equity ratio, the investor should borrow money and use it to buy more shares of the company.

First, calculate the current value of the investor's shares:

500 shares x $2 per share = $1,000

Next, calculate the current amount of debt the company has:

Debt / Equity = 1.0

Equity = $1,000

Debt = $1,000

To achieve a debt-to-equity ratio of 1.5, the company should have $1.50 of debt for every dollar of equity.

Equity = $1,000

Debt = $1,500

Total capital = $1,000 + $1,500 = $2,500

To figure out how much the investor needs to borrow, subtract the current amount of equity from the desired total capital:

Amount to borrow = $2,500 - $1,000 = $1,500

Then, calculate how many new shares the investor can buy with the borrowed money:

$1,500 / $2 per share = 750 new shares

Therefore, the investor should borrow $1,500 and use it to buy 750 new shares. This will increase the debt-to-equity ratio to 1.5, which is the investor's preferred ratio.

An Investor Owns 500 Shares of Stock in a Montreal