Treadless Tires Inc is currently all equity financed. It used to be leveraged, but it recently issued 20,000 new shares at $25 per share. The proceeds from the new issue were used to repay all of its debt
Financial details for the current and old capital structures are presented in the table below.
Assume that Treadless generates perpetual annual EBIT at a constant level. Assume that all cash flows occur at the end of the year and we are currently at the beginning of a year. Assume that taxes are zero. Assume that all of net income is paid out as a dividend. Assume that the debt is perpetual with annual coupons at 4%. Assume that individual investors can borrow and lend at the same interest rate (and with the same terms) as corporations.
Ron Platt is a shareholder in Treadless who owns 5,000 shares. After the new issue, Ron is unhappy with his dividends. How many shares does Ron have to buy (or sell) in order to return his annual cash flows to the level he enjoyed when the company was leveraged?
Capital Structure Capital Structure
Old (Levered) Current (All-Equity)
EBIT $125,000 $125,000
Debt, D $500,000 $0
Cost of Debt, kd 4% N/A
Shares Outstanding 30,000 50,000
Stock Price $25.00 $25.00
Dividends per share $3.50 $2.50
A) Buy 3,333 shares
B) Sell 3,333 shares
C) Buy 4,000 shares
D) Sell 4,000 shares
E) Do nothing. The investment cash flows are identical under each capital structure.
A
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