Question

Deltona, USA is a development company that currently is financed with 100 percent equity. There are 15,000 shares outstanding at a market price of $50 a share. Deltona has earnings before interest and taxes (EBIT) of $20,000. The firm has decided to issue $250,000 of debt at a rate of 8 percent and use the proceeds to repurchase shares. Theresa owns 500 shares of Deltona and wants to use homemade leverage to offset the leverage used by Deltona. Theresa should

Select one:

a. sell 133 shares and invest the proceeds into the debts of Deltona.

b. buy an additional 167 shares.

c. sell 167 shares and invest the proceeds into the debts of Deltona.

Answer 1

	Total Nos of Share	15,000
	Market Value Per Share	$50
	Current Market Valuation    (15000 * $50)	$750,000
	EBIT	$20,000
	Earning Per Share ($20,000 / 15,000)	$1.33
After issue of Debt and repurchase of Shares      :
	Total Nos of Share	10,000
	Market Valuation ($750,000 - $250,000)	$500,000
	EBIT	$20,000
Less:	Interest on Debt ($250,000 * 8%)	$20,000
	EBT (EBIT - Interest on Debt)	0
	Earning per share	0
So the Earning per share will be zero after issue of Debt
Theresa currently holding 500 nos of share
	Current Earning of Theresa (500 * $ 1.33)	$667
After Issue of Debt by Deltona the earning of Theresa will become Nil
So to offset the leverage used by Deltona Theresa needs to change her portfolio
Lets assess the options for Theresa:
a)	Sale of 133 Shares and invest the sale proceeds in Debt issued by Deltona
	Sale proceeds of 133 Shares (133 * $50)	$6,650
	Interest to be received on Debt ($6650 * 8%)	$532
	Earning From Equity Share	Nil
	Total Income Theresa	$532
b)	Buy additional 167 Nos of share
	Investing more in Share will not increase the earning. (As Earning is Nil for Deltona after Debt Issue)
c)	Sell 167 shares and invest into Debts issued by Deltona
	Sale proceeds of 167 Shares (167 * $50)	$8,350
	Interest to be received on Debt ($8,350 * 8%)	$668
	Earning From Equity Share	Nil
	Total Income Theresa	$668
So, to offset the leverage Theresa should go with option C.
Theresa should sell 167 nos of shares and invest the sale proceeds into Debts issued by Deltona