Miller\'s Dry Goods is an all equity firm with 45,000 shares of stock outstandin
ID: 2704345 • Letter: M
Question
Miller's Dry Goods is an all equity firm with 45,000 shares of stock outstanding at a market price of $50 a share. The company's earnings before interest and taxes are $128,000. Miller's has decided to add leverage to its financial operations by issuing $250,000 of debt at 8 percent interest. The debt will be used to repurchase shares of stock. You own 400 shares of Miller's stock. You also loan out funds at 8 percent interest. How many shares of Miller's stock must you sell to offset the leverage that Miller's is assuming? Assume you loan out all of the funds you receive from the sale of stock. Ignore taxes.
A. 35.6 shares
B. 40.0 shares
C. 44.4 shares
D. 47.5 shares
E. 50.1 shares
Explanation / Answer
Hi,
Please find the answer as follows:
Interest = 25000*8% = 20000
Shares Repurchased = 250000/50 = 5000
Number of Shares Outstanding with Debt = 45000 - 5000 = 40000
EPS without any Debt = 128000/45000 = 2.84
EPS with Debt = (128000 - 20000)/40000 = 2.7
Value of Debt = 250000
Value of Stock = 40000*50 = 2000000
Total Value = 250000 + 2000000 = 2250000
Weight of Debt = 250000/2250000 = .11
Weight of Stock = 2000000/ 2250000 = .888889
Initial Investment = 50*400 = 20000
Value on New Stock Position = .888889*20000 = 17777.78
New Shares = 17777.78/50 = 355.56
Number of Shares Sold = 400 - 355.56 = 44.44 shares of 44.4 Shares.
Option C (44.4 Shares) is correct.
Thanks.