Lo Corp. is comparing two different capital structures. Plan I would result in 8
ID: 2763800 • Letter: L
Question
Lo Corp. is comparing two different capital structures. Plan I would result in 8,000 shares of stock and $80,000 in debt. Plan II would result in 6,000 shares of stock and $120,000 in debt. The interest rate on the debt is 6 percent. Assume that EBIT will be $50,000. An all-equity plan would result in 12,000 shares of stock outstanding. Ignore taxes.
What is the price per share of equity under Plan I? Plan II? (Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))
Lo Corp. is comparing two different capital structures. Plan I would result in 8,000 shares of stock and $80,000 in debt. Plan II would result in 6,000 shares of stock and $120,000 in debt. The interest rate on the debt is 6 percent. Assume that EBIT will be $50,000. An all-equity plan would result in 12,000 shares of stock outstanding. Ignore taxes.
Explanation / Answer
Plan I:
No. of shares outstanding in all equity plan = 12,000 shares
No. of shares bought with debt = 12,000 shares – 8,000 shares = 4,000 shares
Value of debt = $80,000
Price per share = $80,000/4,000 shares = $20 per share
Plan II:
No. of shares outstanding in all equity plan = 12,000 shares
No. of shares bought with debt = 12,000 shares – 6,000 shares = 6,000 shares
Value of debt = $120,000
Price per share = $120,000/6,000 shares = $20 per share
This shows that when there are no corporate taxes, the stockholder does not care about the capital structure decision of the firm. This is M&M Proposition I without taxes
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