You currently own 1100 shares of JKL, Inc. JKL is an all equity that has 200000

Question

You currently own 1100 shares of JKL, Inc. JKL is an all equity that has 200000 shares of stock outstanding at a market price of $10 a share. The company's earnings before interest and taxes are $400,000. JKL has decided to issue $1,000,000 million of debt at 10 percent interest. This debt will be used to repurchase shares of stock. Ignore taxes and answer the following two questions:

Part A: What is the target debt to asset ratio? Write as a percent, not a decimal.

Part B: How many shares of JKL stock must you sell to undo the leverage if you can loan out funds at 10 percent interest?

Part A: What is the target debt to asset ratio? Write as a percent, not a decimal.

Part B: How many shares of JKL stock must you sell to undo the leverage if you can loan out funds at 10 percent interest?

Explanation / Answer

Part A:

Since, there is no tax rate, taxes has to be ignored and value of the firm would be the sum of value of debt and equity (without any tax shield).

Value of firm= 200,000/ 0.10

                                = 2,000,000

Value of debt = 1,000,000

Value of Equity = 2,000,000 – 1,000,000

                                = 1,000,000

Debt to asset ratio = amount of debt / value of firm

                                     = 1,000,000 / 2,000,000

                                     = 50%

Part B:

No. of shares to sold = current shares x (1- debt to asset ratio)

                                                = 1100 x (1-0.50)

                                                = 550 shares

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