Question

Company A currently functions as an unlevered firm with 200,000 shares of stock outstanding and a market price of $12 a share. The company's EBIT is $300,000.

The company borrows $500,000, at 5%.

Suppose you are an investor who currently own 10,000 shares of Company A's stock.

If you wish to unlever your position, how many shares will you continue to own, if you can loan out funds at 5 percent interest?

Ignore taxes.

Please show all working and formulas used. Explain any necessary steps.

Answer 1

Total No. of shares repurchased	$ 500000/ $ 12	41667
Shares o/s without debt		200000
Shares o/s with debt	200000-41667=	158333.33
EPS without debt (EPS/No.of shares)	300000/200000=	1.5
Total interest expense	500000*5%=	25000
so, EPS with debt	(300000-25000)/158333=	1.73685
After debt issue,
Value of stock	158333.33*12=	1900000
Value of debt		500000
Total value of A		2400000
Wt. of equity	1900000/2400000=	79.17%
Wt. of debt	500000/2400000=	20.83%
So, value   For the investor
Initial investment	120000
Value of equity	120000*79.17%=	95004
Value of debt	120000*20.83%=	24996
Total		120000
So, no.of shares for the value of equity--to maintain the same unlevered position	95004/12=	7917
		(ANSWER)
Verification:
Earnings before
10000*1.5=		15000
Earnings after debt issue
On shares	7917*1.73685=	13751
On debt	24996*5%=	1250
Total		15000