Parker's Barbecue Inc operates a chain of restaurants in the south eastern United States. Parker's is currently levered. It used to be all-equity, but it recently borrowed and used the money to repurchase 30,000 shares

Question

Financial details for the current and old capital structures are presented in the table below.
Assume that Parker's 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 6%. Assume that individual investors can borrow and lend at the same interest rate (and with the same terms) as corporations.
Duane Allman is a shareholder in Parker's who owns 30,000 shares. After the repurchase, Duane is unhappy with his dividends. How many shares does Duane have to buy (sell) in order to return his annual cash flows to what they were under the all-equity capital structure? (Assume that Duane had the same number of shares under the old structure.)

Capital Structure Capital Structure
Old (All-Equity) Current (Levered)
EBIT $120,000 $120,000
Debt, D $0 $450,000
Cost of Debt, kd N/A 6%
Shares Outstanding 100,000 70,000
Stock Price $15.00 $15.00
Dividends per share $1.20 $1.3286

A) Buy 8,000 shares
B) Sell 8,000 shares
C) Sell 9,000 shares
D) Buy 9,000 shares
E) Buy 7,000 shares

Answer 1

C