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. (15 marks)

The answer is 17556 shares.

Explanation:

Solution

Given that:

Now

In this example of Home made leverage.

It suggests that if taxes are not available 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 is given as:

= 450000 x 15 = 6750000

As taxes are not present, the value of firm will not alter, total value will remain at 6750000

So

After issue of debt, the debt ratio will be given as :

= 825000/6750000 = 12.2222%

This is the important point.

Thus

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

17555.56 = 17556

Therefore, the amount of share you will continue own is 17556 share.

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