XYZ Corp. wants to increase is debt-to-equity ratio from 0.25 to 1.0 by issuing debt and using the proceeds to buy back some of its equity. The current market value of the firm’s assets is $2,000 and there are 800 shares currently outstanding. The firm’s debt is risk-free and perpetual. The current risk-free rate is 6%. Assume the firm’s corporate tax rate is zero and that the share price is not affected by changes in capital structure. You currently own 100 shares of XYZ.
1. Assume the firm decides not to change its capital structure structure, but you want to create the risk-return profile of the more highly levered firm. What percentage of the current firm’s equity should you own to achieve your objective?
A) 10.0%
B) 12.5%
C) 15.6%
D) 17.8%
E) 20.0%
2. Continuing the above question, specifically how would you achieve your objective?
A) Borrow $320 at 6% and buy 160 more shares
B) Borrow $200 at 6% and buy 100 more shares
C) Borrow $120 at 6% and buy 60 more shares
D) Borrow $ 60 at 6% and buy 40 more shares
E) Borrow $ 20 at 6% and buy 20 more shares
3. Now assume that the firm changes to the new capital structure (debt-to-equity ratio of 1.0), so you now own 100 shares of the more highly levered firm. However, you prefer a debt-to equity ratio of 0.6. How would you achieve your objective now?
A) Invest $25 at 6% and sell 12.5 shares
B) Invest $40 at 6% and sell 20 shares
C) Invest $50 at 6% and sell 25 shares
D) Invest $60 at 6% and sell 30 shares
E) Invest $74 at 6% and sell 37.5 shares