Jungle Cat Petting Zoo Inc is currently all equity financed. It used to be leveraged, but it recently issued 5,000 new shares at $50 per share. The proceeds from the new issue were used to repay all of its debt

Question

Financial details for the current and old capital structures are presented in the table below.
Assume that Jungle Cat 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 3%. Assume that individual investors can borrow and lend at the same interest rate (and with the same terms) as corporations.
Leo Delgato is a shareholder in Jungle Cat who owns 6,750 shares. After the new issue, Leo is unhappy with his dividends. How many shares does Leo 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 $250,000 $0
Cost of Debt, kd 3% N/A
Shares Outstanding 45,000 50,000
Stock Price $50.00 $50.00
Dividends per share $2.611 $2.50

A) Buy 750 shares
B) Sell 750 shares
C) Buy 675 shares
D) Sell 675 shares
E) Do nothing. The investment cash flows are identical under each capital structure

Answer 1

A