Learn and Earn Company is financed entirely by common stock that is priced to offer a 20 percent expected rate of return. The stock price is $60 and the earnings per share are $12. The company wishes to repurchase 50 percent of the stock and substitutes an equal value of debt yielding 8 percent. Suppose that before refinancing, an investor owned 100 shares of Learn and Earn common stock. What should he do if he wishes to ensure that risk and expected return on his investment are unaffected by this refinancing?
A)Borrow $3,000 and buy 50 more shares.
B)Continue to hold 100 shares.
C)Sell 50 shares and purchase $3,000 of 8 percent debt (bonds).
D)Sell 8 percent of his stock and invest in bonds.

Question

Quizplus · Accepted Answer

By selling 50 shares and reinvesting the proceeds in the debt yielding 8 percent, the investor will be able to maintain the same expected rate of return but will reduce the risk by substituting a less risky asset (debt) for a riskier asset (common stock). This will also help to offset the potential negative impact on the stock price due to the repurchase of shares. Option A is not a good choice since it involves borrowing and increasing risk. Option B is not a good choice as it does not take into account the effect of the refinancing on the risk-return tradeoff. Option D is not a good choice as it involves a relatively small amount of money and does not adequately address the impact of the refinancing on the investor's portfolio.

Learn and Earn Company Is Financed Entirely by Common Stock