Suppose that Lil John Industries’ equity is currently selling for $35 per share and that 2.8 million shares are outstanding. The firm also has 58,000 bonds outstanding, which are selling at 104 percent of par. Assume Lil John was considering an active change to its capital structure so that the firm would have a (D/E) of 1.3. Which type of security (stocks or bonds) would it need to sell to accomplish this? Sell bonds and buy back stock Sell stock and buy back bonds How much would the firm have to sell?

Explanation:

Given that :

Current share price = $35

Share outstanding = 28,000, 000

Bond outstanding = 58,000

current bond price = 104 % par value

Default par value of the bond = $1000

Target Debt /Equity ratio = 1.3

The  type of security (stocks or bonds)  it would need to sell to accomplish this is as follows:

Total debt = current bond price × bonds outstanding

= 104% par value × 58000

= 104 % × 1000 × 58000

= $ 60,320,000

Total equity = current share price × shares outstanding

Total equity = 35 × 28,000,000

Total equity = $ 98,000,000

Current debt-equity ratio  = Total debt/ total equity

=  $ 60,320,000/ $ 98,000,000

= 0.62

Hence , the current debt ration is 0.62 which is less than the target 1.3. Thus, the company needs to issue debt  bonds  to buy-back shares  to make changes in the capital structure  in order to achieve the target capital structure of 1.3

How much to be sold to achieve the target capital structure of 1.3

Total Value = Debt + Equity

Total Value = 60,320,000 + 98,000,000

Total Value = 158,320,000

Current debt ratio = Debt/total value

Current debt ratio = 60,320,000/158,320,000

Current debt ratio = 0.381

Required debt ratio =  Target dent ratio/1+ target debt ratio

Required debt ratio = 1.3/1+1.3

Required debt ratio = 1.3/2.3

Required debt ratio = 0.5652

Debt to be sold = (Target debt ratio - current debt ratio) × Total value

Debt to be sold = (0.5652 - 0.381) × 158,320,000

Debt to be sold = 0.1842  × 158,320,000

Debt to be sold = $29,162,544

Hence, the new debt to be sold is $29,162,544 to achieve target debt equity ratio of 1.3

Verify:

New debt = Old Debt +New debt sold

New debt =  $60,320,000 + $29,162,544

New debt = $89,482,544

New Equity = Old Equity - New Equity   (i.e new debt sol/buy back share)

New Equity = $98,000,000 - $29,162,544

New Equity = $68,837,456

New debt equity ratio = New debt/ New equity

New debt equity ratio = $89,482,544/ $68,837,456

New debt equity ratio = 1.299

New debt equity ratio ≅ 1.3 Target D/E ratio

Hopes that helps a lot!

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