Question

You currently own 1000 shares of JKL Inc.. JKL is an all equity firm that has 80,000 shares of stock outstanding at a market price of $50 a share. The company's earnings before interest and taxes are $140,000. JKL has decided to issue $1 million of debt at 8 percent interest. This debt will be used to repurchase shares of stock. If you prefer the original capital structure of 100% equity and the associated payoffs, you will take which of the following actions to achieve the original payoffs (under 100% equity)?

a. borrow $37,500 at 8% to purchase another 750 shares.
b. borrow $12,500 at 8% to purchase another 250 shares.
c. sell 500 shares and loan out the proceeds at 8%
d. sell 250 shares and loan out the proceeds at 8%
e. None of the above

Answer 1

The correct option is d. sell 250 shares and loan out the proceeds at 8%

Step-by-step explanation:

Based on the information given in a situation where you prefer the original capital structure of 100% equity as well as the associated payoffs,

the actions to achieve the ORIGINAL PAYOFFS

under 100% equity will be to SELL 250 shares and LOAN out the proceeds at 8% reason been if the proceeds of 8% is loan out it will be used to repurchase shares of stock.

CALCULATION for the 250 shares which is the number of shares sold

First step is to calculate Your initial investment

Your initial investment = 1,000 sharesx $50 per share

Your initial investment= $50,000

Second step is to calculate JKL value of stock

JKL value of stock = [80,000 - ($1M/$50 per share)] x $50 per share

JKL value of stock =(80,000-20,000)×$50 per share

JKL value of stock =60,000×$50 per share

JKL value of stock = $3M

Third step is to calculate JKL Total value

JKL Total value = 3M + 1M

JKL Total value = 4M

Fourth step is to find JKL Wight Stock using this formula

JKL Wight Stock=JKL value of stock/JKL Total value

Let plug in the formula

JKL Wight Stock = 3M/4M

Fifth Step is to calculate You new stock position

You new stock position =[ 3M/4M($50,000) ]/$50 share

You new stock position = $37,500/50 per shares

You new stock position = 750

Last step is to calculate the Number shares sold

Number shares sold = 1,000 shares - 750

Number shares sold = 250 shares