Gabella's is an all-equity firm that has 21,000 shares of stock outstanding at a market price of $40 a share.The firm has earnings before interest and taxes of $84,000 and has a 100 percent dividend payout ratio.Ignore taxes.Gabella's has decided to issue $160,000 of debt at a rate of 12 percent and use the proceeds to repurchase shares.Terry owns 400 shares of Gabella's stock and has decided to continue holding those shares.How will Gabella's debt issue affect Terry's annual dividend income?
A)Decrease from $2,400 to $1,840
B)Increase from $2,400 to $2,160
C)Decrease from $1,600 to $1,525
D)Increase from $1,600 to $2,094
E)No change

Question

Quizplus · Accepted Answer

All-equity EPS = $84,000/21,000 = $4Debt-equity EPS = [$84,000 - ($160,000 × 0.12)]/[21,000 - ($160,000/$40)] = $3.8118Terry's all-equity dividend income = 400 × $4 = $1,600Terry's debt-equity dividend income = 400 × $3.8118 = $1,525

Gabella's Is an All-Equity Firm That Has 21,000 Shares of Stock