Question

Lara’s Inc. is currently an unlevered firm with 450,000 shares of stock outstanding, with a market price of $15 a share. The company has earnings before interest and taxes of $314,000. Lara's met with his bankers, Warne Incorporated and agreed to borrow $825,000, at 5 percent. You are an ardent investor and you currently own 20,000 shares of Lara's stock. If you seek to unlevered your position; how many shares of Lara's stock will you continue to own, if you can loan out funds at 5 percent interest? Ignore taxes in your deliberations. Kindly show all workings.

Answer 1

There are 2 cases here which we are going to discuss.

First case:

The company Lara'Inc earnings before interest and tax (EBIT) = $3,14,000

Unlevered means that the company has no debt. So there is no Inerest component and ignoring the taxes earnings after tax (EAT) = $3,14,000

EAT= $3,14,000

Earnings per share= (Net profit-preferred dividends)/Number of shares outstanding in the market

Number of shares outstanding in the market= 4,50,000

Preferred Dividends=$0 (Assumption the company has not issued any preferred dividends)

EPS= (314000/450000)=0.6978 (Round off to 4 digits after decimal)

The investor owns 20,000 shares.

By holding 1 share investor earns $0.6978

So with total of 20,000 shares investor earns =(20000*0.6978)=$13,956

$13,956 is a nominal amount as investor has not sold any shares.

P/E in this case is (15/0.6978)=$21.50 (rounded off)

Total market cap of Lara's Inc is (15*450000)=$67,50,000

Second Case

The investor loan out funds of $8.25,000 at 5%

The interest component would be (8,25,000*0.05)= $41,250

For Lara's Inc the interest is $41,250

So Earnings before tax is calculated by deducting interest component from EBIT which is = (314000-41250)=$2,72,250

EBT(Earnings before tax)= EBIT-I= $2,72,250

EAT=EBT-t= $2,27,250-$0=$2,72,250

So EPS= (272250/450000)=$0.605

Assuming P/E remains same.

Therefore new market price is (0.605*21.50)= $13 (Market price for Lara's Inc)

Therfore new market cap =(450000*13)=$58,50,000

Decline in market cap is $67,50,000-$58,50,000=$9,00,000

Loss for the investor would be ($2*20,000)=$40,000

So the investor in order to unlevered it will try to gain this amount by selling in the market which will be ($40000/15)= 2667 shares

Therefore the investor holds 17,333 shares