EPS $ 1.25 Earnings for 200 shares 250.00 Less: Interest on $2,000 at 10% 200.00

$ 2.50 500.00 200.00

$ 3.75 750.00 200.00

Net earnings $ 50.00 Net cost = 200 shares x $20 - Amount borrowed =

$300.00 $4,000 - 2,000

$550.00 = $2,000

Now, suppose that Trans Am does not adopt the proposed capital structure. In this case, EPS will be $1.25, $2.50, or $3.75. The second part of Table 17.5 demonstrates how a stockholder who prefers the payoffs under the proposed structure can create them using personal borrowing. To do this, the stockholder borrows $2,000 at 10 percent on their own. Our investor uses this amount, along with the original $2,000, to buy 200 shares of stock. As shown, the net payoffs are exactly the same as those for the proposed capital structure.

How did we know to borrow $2,000 to create the right payoffs? We are trying to replicate Trans Am's proposed capital structure at the personal level. The proposed capital structure results in a debt-equity ratio of 1. To replicate this structure at the personal level, the stockholder must borrow enough to create this same debt-equity ratio. Because the stockholder has $2,000 in equity invested, the borrowing of another $2,000 will create a personal debt-equity ratio of 1.

This example demonstrates that investors can always increase financial leverage themselves to create a different pattern of payoffs. It thus makes no difference whether or not Trans Am chooses the proposed capital structure.

Unlevering the Stock

In our Trans Am example, suppose management adopts the proposed capital structure. Further suppose that an investor who owned 100 shares preferred the original capital structure. Show how this investor could "unlever" the stock to recreate the original payoffs.

To create leverage, investors borrow on their own. To undo leverage, investors must loan out money. In the case of Trans Am, the corporation borrowed an amount equal to half its value. The investor can unlever the stock by simply loaning out money in the same proportion. In this case, the investor sells 50 shares for $1,000 total and then loans out the $1,000 at 10 percent. The payoffs are calculated in the following table.

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