Martin and Sons (M and S) currently is an all equity firm with 48,000 shares of

Question

Martin and Sons (M and S) currently is an all equity firm with 48,000 shares of stock outstanding at a market price of $30 a share. The company's earnings before interest and taxes are $82,000. M and S has decided to add leverage to their financial operations by issuing $570,000 of debt with a 8% percent interest rate. This $570,000 will be used to repurchase shares of stock. You own 1,200 shares of M and S stock. You also loan out funds at a 8% percent rate of interest. How many of your shares of stock in M and S must you sell to offset the leverage that the firm is assuming? Assume that you loan out all of the funds you receive from the sale of your stock.

Explanation / Answer

Market price per share = 30

Debt issue = 570000

Share to be repurchased = 570000/30 = 19000

Ratio of repurchase = 19000/48000

Same ratio is applied by you to offset the leverage = 1200*19/48 = 475

Before leverage Eps = 82000/48000 = 1.7083

Your earning on 1200 shares = 1200*1.7083 = 2050

After leverage EPS = 82000-(570000*0.08) / (48000-19000)

= 36400/29000 = 1.2552

Your earning on (1200-475) shares = 725*1.2552 =910

Your earning on fund invested @ 8% of shareselling = (475*30)*8%

= 1140

Your total earning = 910+1140 = 2050, i.e effect of leverage set off

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