You currently own 600 shares of JKL,Inc.JKL is an all equity firm that has 75,000 shares of stock outstanding at a market price of $40 a share.The company's earnings before interest and taxes are $140,000.JKL has decided to issue $1 million of debt at 8 percent interest.This debt will be used to repurchase shares of stock.How many shares of JKL stock must you sell to unlever your position if you can loan out funds at 8 percent interest?
A)120 shares
B)150 shares
C)180 shares
D)200 shares
E)250 shares

Question

Quizplus · Accepted Answer

JKL interest = $1m × 0.08 = $80,000JKL shares repurchased = $1m/$40 = 25,000JKL shares outstanding with debt = 75,000 - 25,000 = 50,000JKL EPS, no debt = $140,000/75,000 = $1.866667JKL EPS, with debt = ($140,000 - $80,000)/50,000 = $1.20JKL value of stock = 50,000 × $40 = $2mJKL value of debt = $1mJKL total value = $2m + $1m = $3mJKL weight stock = $2m/$3m = 2/3JKL weight debt = $1m/$3m = 1/3Your initial investment = 600 × $40 = $24,000Your new stock position = 2/3($24,000) = $16,000Your new number of shares = $16,000/$40 = 400Number of shares sold = 600 - 400 = 200 sharesCheck:Your new loans = 1/3($24,000) = $8,000Your unlevered income = 600 × $1.866667 = $1,120Your levered income = (400 × $1.20) + ($8,000 × 0.08) = $1,120

You Currently Own 600 Shares of JKL,Inc