Question

Lara’s Inc. is currently an unlevered firm with 450,000 shares of stock outstanding, with a market price of $15 a share. The company has earnings before interest and taxes of $314,000. Lara's met with his bankers, Warne Incorporated and agreed to borrow $825,000, at 5 percent. You are an ardent investor and you currently own 20,000 shares of Lara's stock. If you seek to unlevered your position; how many shares of Lara's stock will you continue to own, if you can loan out funds at 5 percent interest? Ignore taxes in your deliberations. Kindly show all workings.

Answer 1

It is a case of Home made leverage.

It implies that if taxes are not present and no other costs are there, an investor can create capital structure similar to Firm.

Here, firm is proposing to borrow 825000.

The all equity firm value = 450000 x 15 = 6750000

As taxes are not there, the value of firm will not change, total value will remain at 6750000

So after issue of debt, the debt ratio will be = 825000/6750000 = 12.2222%

This is the important point.

To create same capital structure, you have to sell 12.2222% of your shares and the amount received from sale of shares, purchase debt

So you have to sell = 12.2222% x 20000 = 2444.44 shares

and continue to hold = 20000 - 2444.44 = 17555.56 share

Answer : 17555.56 = 17556 [rounding] [Thumbs up please]