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16 May, 18:54

Gabella's is an all-equity firm that has 36,000 shares of stock outstanding at a market price of $27 a share. The firm has earnings before interest and taxes of $57,600 and has a 100 percent dividend payout ratio. Ignore taxes. Gabella's has decided to issue $125,000 of debt at a rate of 9 percent and use the proceeds to repurchase shares. Terry owns 800 shares of Gabella's stock and has decided to continue holding those shares. How will Gabella's debt issue affect Terry's annual dividend income?

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  1. 16 May, 22:39
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    Terry's annual dividend income will aecrease from $640 to $591

    Explanation:

    Given

    Earnings before interest and taxes = $57,600

    Market Price Share = $27

    Stock = 36,000 shares

    Debt = $125,000

    Debt rate = 9%

    First, we calculate the all equity Earnings per share

    This is calculated by dividing earnings by outstanding stock

    All-equity EPS = $57,600/36,000

    All equity EPS = $1.60

    Then we calculate the Debt and equity EPS

    This is calculated by (Earnings - Debt * Debt Rate) / (Stock - Debt/Market Price Share)

    Debt and equity EPS = [$57,600 - ($125,000 *.09) ]/[36,000 - ($125,000/$27) ]

    Debt and Equity EPS = $1.4775

    Calculating Terry's all-equity dividend income

    = 400 * $1.60 = $640

    Calculating Terry's debt and equity dividend income

    = 400 * $1.4775 = $591

    Terry's annual dividend income will aecrease from $640 to $591
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