Question

Suppose that Lil John Industries’ equity is currently selling for $38 per share and that 3.1 million shares are outstanding. The firm also has 61,000 bonds outstanding, which are selling at 104 percent of par. Assume Lil John was considering an active change to its capital structure so that the firm would have a (D/E) of 1.3. Which type of security (stocks or bonds) would it need to sell to accomplish this? sell bonds and buy back stock sell stocks and buy back bonds How much would the firm have to sell in dollars?

Answer 1

Present structure

Particulars	Price = P	Quantity = Q	Value = P x Q	Weights
Equity	38	3100000	117800000	64.9967%
Debt	1040	61000	63440000	35.0033%
		Total	181240000	100.0000%

Revised structure:

Total capital = 181240000

Debt weight = 1.3/2.3; Equity weight = 1/2.3 (Debt equity ratio is 1.3)

Debt Capital = Total Capital x Debt weight = 181240000 x 1.3/2.3 = $102440000

Equity capital = Total capital x equity weight = 181240000 x 1/2.3 = $78800000

Hence,

We need to buy back equity and finance that buy back from debt because in present structure we have higher equity and low debt to achieve debt equity ratio of 1.3

Borrow debt = $102440000 - $63440000 = $39000000

Buy back equity = $117800000 - $78800000 = $39000000