Miller\'s Dry Goods is an all equity firm with 48,000 shares of stock outstandin
ID: 2716851 • Letter: M
Question
Miller's Dry Goods is an all equity firm with 48,000 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.
41.67 shares
D.
47.5 shares
E.
50.1 shares
Explanation / Answer
SHARES OUTSTANDING=$48,000
MARKET PRICE PER SHARE=$50
EARNING BEFORE INTEREST AND TAX=$1,28,000
DEBT TO BE ISSUED=$2,50,000
INTEREST ON DEBT=8%*$2,50,000=$20,000
FINANCIAL LEVERAGE=EARNING BEFORE INTEREST AND TAX/EARNING BEFORE TAX
=$1,28,000/$1,28,000-$20,000
=1.185
CALCULATION OF SHARES OF MILLER'S STOCK TO BE SOLD:
SHARES TO BE REPURCHASED= $250,000/$50 = 5,000
REMAINING SHARES = 48,000 - 5,000 = 43,000
MILLER'S EPS WHEN NO DEBT= $128,000/48,000 = $2.67
MILLER'S EPS WITH DEBT = ($128,000 - $20,000)/43,000 = $2.51
MILLER'S VALUE OF STOCK = 43,000 x $50 = $21,50,000
MILLER'S VALUE OF DEBT = $250,000
MILLER'S TOTAL VALUE = $21,50,000 +$250,000 = $24,00,000
WEIGHT OF STOCK= $21,50,000/$24,00,000 = 0.8958
WEIGHT OF DEBT = $250,000/$24,00,000 =0.1042
MY INITIAL INVESTMENT = 400 x $50 = $20,000
MY NEW STOCK POSITION= 0.8958 x $20,000 = $17,916
MY NEW NO.OF SHARES= $17,916/$50 = 358.32
NUMBER OF SHARES SOLD = 400 - 358.32 = 41.68 SHARES
HENCE (c)41.67 SHARES IS CORRECT