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?

A. 120 shares B. 150 shares C. 180 shares D. 200 shares E. 250 shares

Explanation / Answer

D. 200 shares

The initial investment = 600 x $40 = $24,000

JKL value of stock = [75,000 - ($1M/$40)] x $40 = $2M
Value of Debt = 1M
JKL Total value = 2M + 1M = 3M
JKL new Stock position = 2M/3M = 2/3

Your new stock position = 2/3 x $24,000 (i.2 2/3 of initial investment) = $16,000 (i.e $16000/40=400 shares)

So, Number shares sold = 600 - 400 = 200 shares

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