Chapter 17, Problem 1PS

Homemade leverage* Ms. Kraft owns 50,000 shares of the common stock of Copperhead Corporation with a market value of $2 per share, or $100,000 overall. The company is currently financed as follows:

Copperhead now announces that it is replacing $1 million of short-term debt with an issue of common stock. What action can Ms. Kraft take to ensure that she is entitled to exactly the same proportion of profits as before?

Summary Introduction

To discuss:  The action has to be taken by person K to ensure she is entitled to exactly the same proportion of profits as before.

Explanation of Solution

The market value of company C is very higher than the book value and the computation of ownership percent and borrowing amount is as follows:

$\begin{array}{c}\text{Ownership percent}\text{=}\frac{\text{Shares owned}}{\text{total shares}}\\ =\frac{50,000}{8\text{m}}\\ =0.00625\text{or 0}\text{.625\%}\end{array}$

$\begin{array}{c}\text{Borrow amount = ownership percent}\times \text{firm's debt reduction}\\ \text{=0}\text{.625\%}\times \text{1 million}\\ \text{=\$6,250}\end{array}$

The person K has 0.625% holding in the firm and which proposes the following:

• Increase common stock to $17 million.
• Decrease the short-term debt by $1 million.

Person K set of the change ion firms capital structure by borrowing $6,250 and acquiring more shares of company C.