Question

Suppose that a company's equity is currently selling for $24.75 per share and that there are 3.3 million shares outstanding and 13 thousand bonds outstanding, which are selling at 94 percent of par. If the firm was considering an active change to their capital structure so that the firm would have a D/E of 0.6, which type of security (stocks or bonds) would they need to sell to accomplish this, and how much would they have to sell? (Round your intermediate ratio to 4 decimal places.)

• $20,051,213 in new equity

• $23,035,265 in new debt

• $23,035,265 in new equity

• $20,051,213 in new debt

Answer 1

Market value of equity E = Number of shares * stock price = 3.3 million *$24.75 = $81.675 million

Market value of debt D = number of bonds outstanding * face value * selling at % of par

= 13,000 * $1000 * 94% = $12.22 million (Face value of bond is assumed $1000 per bond)

Total asset = Market value of equity E + Market value of debt D

(D +E)= $81.675 million +$12.22 million

= $93.895 million

Current D/E ratio = Market value of debt D/ Market value of equity E

=$12.22 million/ $81.675 million = 0.1496

If the firm was considering an active change to their capital structure so that the firm would have a D/E of 0.6; then firm has to increase it D/E ratio from current 0.1496 to 0.6. Therefore firm has to issue new debt and have to use proceeds to repurchase its stock

Now, we have two equations tow calculate new value of D –

D/E = 0.6 or E = D/0.6

And (D +E) = $93.895 million

Therefore,

(D + D/0.6) = $93.895 million

Or 2.67 D = $93.895 million

Or D = $93.895 million / 2.6667 = $35.255265 million

Therefore value of new debt is the increase in total debt = Market value of total debt (new) - Market value of total debt (initial)

= $35,255,265 - $12,220,000 = $23,035,265

Therefore correct answer is option: $23,035,265 in new debt