You own 400 shares of Kaiser. Kaiser is currently an all equity firm that has 12,000 shares of stock outstanding at a market price of $50 a share. The company's earnings before interest and taxes are $20,000. The dividend payout ratio is 100%. Kaiser has decided to issue $100,000 of debt at a 9% rate of interest. This $100,000 will be used to repurchase shares of stock. How many shares of Kaiser stock must you sell to unlever your position if you can loan out funds at a 9% rate of interest?

A) 67 shares
B) 100 shares
C) 133 shares
D) 160 shares
E) 200 shares

Question

Maribel Medina · Accepted Answer

Final Answer : A, Explanation :  The correct answer is A.The company's earnings before interest and taxes are $20,000. The dividend payout ratio is 100%. So, the dividends paid are $20,000. The company has 12,000 shares of stock outstanding. So, the earnings per share are $20,000 / 12,000 = $1.67. The market price of the stock is $50. So, the price-to-earnings ratio is $50 / $1.67 = 30. The company is issuing $100,000 of debt at a 9% rate of interest. So, the interest expense will be $100,000 * 9% = $9,000. The new earnings per share will be ($20,000 - $9,000) / 12,000 = $0.92. The new price-to-earnings ratio will be $50 / $0.92 = 54.35. The number of shares that must be sold to unlever the position is 400 * (30 / 54.35) = 67 shares.

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