Question 16.2: In our Trans Am example, suppose management adopts the propo...
In our Trans Am example, suppose management adopts the proposed capital structure. Further suppose that an investor who owns 100 shares prefers the original capital structure. Show how this investor could “unlever” the stock to re-create the original payoffs.
To create leverage, investors borrow on their own. To undo leverage, investors must lend money. In the case of Trans Am, the corporation borrowed an amount equal to half its value. The investor can unlever the stock by lending money in the same proportion. In this case, the investor sells 50 shares for $1,000 total and then lends the $1,000 at 10 percent. The payoffs are calculated in the following table:
| Recession | Expected | Expansion | |
| EPS (proposed structure) | $ .50 | $ 3.00 | $ 5.50 |
| Earnings for 50 shares | 25.00 | 150.00 | 275.00 |
| Plus: Interest on $1,000 | \underline{100.00} | \underline{100.00} | \underline{100.00} |
| Total payoff | $125.00 | $250.00 | $375.00 |
These are precisely the payoffs the investor would have experienced under the original capital structure.