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Basic Question 1 of 15
Tom owns 100 shares of stock in a firm whose debt/equity ratio is 1.0. He prefers a debt/equity ratio of zero. If the market price per share is $60, what should Tom do?
B. sell 100 shares and lend $6,000
C. sell 50 shares and lend $3,000
D. borrow $1,500 and buy 25 new shares
E. borrow $3,000 and buy 50 new shares
A. borrow $3,000 and buy 100 new shares
B. sell 100 shares and lend $6,000
C. sell 50 shares and lend $3,000
D. borrow $1,500 and buy 25 new shares
E. borrow $3,000 and buy 50 new shares
User Contributed Comments 14
| User | Comment |
|---|---|
| kalps | Anyone care to explain ?? |
| sekib | This one really doesn't make sense: I think B is the correct answer because any share of stock he has left will represent some level of debt |
| tony1973 | Yes it makes sense: the amount you lend will cancel out the amount you borrow (indirectly from owning the stock). |
| Arron | by doing as what C states, Tom actually changes the debt/equity ratio of his PORTFOLIO to zero: 50% shares + 50% debt securities or equal. |
| haarlemmer | I think this case needs to be addressed by Tom's personal prespective. Since he does not want debt, selling 50 shares and lending the cash out will create him a position that he could balance out the debt. In that sense, he is debt free. |
| SueLiu | But why is B wrong? |
| dlo1 | Good question actually. The answer is "C" because by selling 50 shares and lending the proceeds worth $3000, Tom has 50 shares remaining worth exactly $3000. As the debt/equity ratio of the firm is 1:1, the $3000 worth of shares is accompanied by $3000 worth of debt. Tom achieves a 0 debt/equity ratio by lending the equivalent amount of debt as the company borrows. |
| xyzanand | True that with C, Tommy would get 0 debt to equity but even with B, Tommy will grab his goal. |
| kodali | With C both debt and equity will be 0 so it will be 0/0 With B effective debt is 0 but equity will be non-zero |
| RavG | MV of shares is different from BV of shares Here, you've to assume that MV of shares = total assets So, 6000 (total assets) = 3000 (Debt) + 3000 (Equity) Now, lend 3000 (presumably from cash assets) or use it to retire the 3000 debt |
| bani007 | RavG Tom owns 100 x 60 = 6000 Equity is 6,000 not total assets Market value of shares cannot equal total assets |
| gregsob2 | still dont understand the difference between b and c |
| daverco | Me neither. If you have equal dollar amounts debt and equity, then the ratio is 1, not 0. That seems to be true whether from a company or personal-portfolio perspective. Tom actually starts out with a zero debt-to-equity ratio (0/$6000). Answer C seems to point to how Tom can achieve the company's debt-to-equity ratio of 1 ($3000/$3000). |
| davidt87 | I'm seeing another problem, Tom's remaining 50 shares represent $1,500 of debt and $1,500 of equity. Add the $3,000 he lends in answer C into the mix, and now Tom has $1,500 equity and is a net lender of $1,500 ($1,500 - $3,000). I think he needs to sell 33 shares and lend $2,000 to completely hedge any debt exposure. |
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Learning Outcome Statements
explain the Modigliani-Miller propositions regarding capital structure;
CFA® 2024 Level I Curriculum, Volume 4, Module 34.