You currently own 600 shares of JKL, Inc. JKL is an all equity firm that has 75,

Question

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? Ignore taxes.
HINT: You unwind leverage by holding debt and equity in the levered company that is proportional to the levered company's capital structure. Start by finding the new capital structure (debt-equity ratio) if the firm issues the debt.

120 shares

150 shares

180 shares

200 shares

250 shares

Explanation / Answer

JKL Interest = 1000000* 8% = $80000

JKL shares repurchased = 1000000 / 40 = 25000 shares

JKL shares outstanding with debt = 75000 - 25000 = 50000 shares

JKL EPS, no debt = 140000 / 75000 = $1.867

JKL EPS, with debt = (140000-80000) / 75000 = $0.80

Unlevered Income from JKL = 600 * 1.867 = $1120

Levered Income from JKL = 600 * 0.80 = $ 480

JKL Value of Stock = 50000 * 40 = $2000000

JKL Value of Debt = $1000000

JKL Total Value = 2000000 + 1000000 = $3000000

JKL Weight Stock = 2000000/ 3000000 = 0.667

JKL Weight Debt = 1000000/ 3000000 = 0.333

Initial Investment = 600 * 40 = $24000

New Stock Position = 0.667 * 24000 = $16000

New No. of Shares = 16000 / 40 =400

New Loans = 0.333 * 24000 = $8000

Unlevered Income = 600 * 1.867 = $1120

Levered Income = (400* 0.80) + (8000 * 0.08) = $960

No.of Shares Sold = 600 - 400 = 200 Shares

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