Question
Learn and Earn Company is financed entirely by common stock. The stock price is $60 and the company wishes to repurchase 50% of the stock
Learn and Earn Company is financed entirely by common stock. The stock price is $60 and the company wishes to repurchase 50% of the stock and substitutes an equal value of debt yielding 8%. Suppose that before refinancing, an investor owns 100 shares of the firms common stock. What should he do if he wishes to ensure the identical return on his investment? Ignore taxes and costs of financial distress.
a. Borrow $3,000 and buy 50 more shares b. Continue to hold 100 shares c. Sell 50 shares and purchase $3,000 of 8% yielding bonds d. Sell 8% of his stock and invest in bonds
Explanation: To create an unlevered position in the firm, the investor needs to take a vertical slice of the capital structure of the firm. Specifically, the investor needs to invest, for each dollar of investment funds, L=D/V dollars in the firms bonds (or similar bonds) and 1 L dollars in the levered equity of the firm. In this problem, the investor has (60)(100) = $6,000, and should invest (0.50)(6,000) = $3,000 in bonds and (1 0.50)(6,000) = $3,000 in levered equity.
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