Suppose that Lil John Industries’ equity is currently selling for $43 per share

Question

Suppose that Lil John Industries’ equity is currently selling for $43 per share and that 3.6 million shares are outstanding. The firm also has 66,000 bonds outstanding, which are selling at 102 percent of par. Assume Lil John was considering an active change to its capital structure so that the firm would have a (D/E) of 1.5. Which type of security (stocks or bonds) would it need to sell to accomplish this? sell bonds and buy back stock sell stocks and buy back bonds How much would the firm have to sell?

Explanation / Answer

Value of Equity = $43 * 3600000 = $154,800,000

Value of Bond = 66000 * $1000 * 1.02 = $67,320,000

Current D/E ratio = 67320000/154800000 = .435

So company has to sell the stocks and buy back bonds to increase the D/E ratio as 1.5

Firm Value = Value of equity + value of bond = $222,120,000

Value of equity should be = Firm Value/2.5 = $88,848,000

Firm has to sell (154800000 - 88848000) $65952000 worth of equity to reach the desired capital structure.

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