You currently own 600 shares of JKL, Inc. JKL is an all equity that has 400000 shares of stock outstanding at a market price of $10 a share. The company’s earnings before interest and taxes are $800,000. You believe that the JKL should finance 66.67 percent of assets with debt, but management refuses to leverage the company. Given that similar firms’ pay 12 percent interest on their debt, answer the following questions.
Part A: How much money should you borrow to create the leverage on your own? Assume you can borrow funds at 12 percent interest.
Part B: How many additional shares of JKL stock must you purchase to create the leverage on your own?
JKL interest = $2,666,800 × 0.12 = $320016
JKL shares repurchased = $2666800/$10 = 266,680
JKL shares outstanding with debt
= 400,000 -266680
= 133,320
JKL EPS, no debt
= $800,000/400,000 = $2
JKL EPS, with debt
= ($800000 – $320016)/133320
= $3.6
JKL value of stock
= 133320 × $10
= $1333200
JKL value of debt = $266680
JKL total value = $2666800 + $133320
= $4000000
JKL weight stock = 1/3
JKL weight debt = 2/3
Your initial investment
= 600 × $10
= $6000
Your new stock position
= 1/3($6,000)
= $2,000
Your new number of shares
= $2,000/$10
= 200
Number of shares sold
= 600 – 200
= 400 shares
