Suppose that a company's equity is currently selling for $22 per share and that there are 4 million shares outstanding and 30 thousand bonds outstanding, which are selling at 101 percent of par ($1,000). If the firm was considering an active change to their capital structure so that the firm would have a D/E of 0.9, which type of security (stocks or bonds) would they need to sell to accomplish this, and how much would they have to sell?

Question

Quizplus · Accepted Answer

To achieve a D/E ratio of 0.9, the company needs to adjust its capital structure. The current market value of equity is $22 * 4,000,000 = $88,000,000. The current market value of debt is 30,000 * $1,000 * 1.01 = $30,300,000. For a D/E of 0.9, Debt = 0.9 * Equity. Substituting the current equity value, we get $30,300,000 + New Debt = 0.9 * ($88,000,000 + New Equity). Since we're solving for new debt and assuming no new equity is issued (as the goal is to adjust through debt), New Debt = 0.9 * $88,000,000 - $30,300,000 = $79,200,000 - $30,300,000 = $48,900,000. The new total debt required is $30,300,000 + $48,900,000 = $79,200,000. The amount of new debt needed is $79,200,000 - $30,300,000 = $48,900,000. However, the correct calculation involves setting the desired D/E ratio and solving for the amount of new debt needed to achieve this ratio, which was not correctly reflected in the final step of this explanation. The correct approach involves calculating how much new debt is needed to achieve a total debt that results in a D/E ratio of 0.9 when compared to the current equity.

Suppose That a Company's Equity Is Currently Selling for $22