Question 10 - 8 Say you decide to start a firm and you need $500 million of capi

Question

Question 10 - 8Say you decide to start a firm and you need $500 million of capital to begin. You sell stock for its par value, a total of one million shares (par value is $200 per share), and sell $300 million of bonds at par value. You use the capital you just raised to buy $500 million of equipment. Assume that the average cost of capital = 12%. In the first year of operation, EBIT = $105 million, tax rate 40% and the required rate of return on equity is 22%. Assume that the market expects that the firm will continue to grow its Economic Profit at a rate of 6% annually, what is the market price per share of stock?

Explanation / Answer

Solution:

To compute the market price per share we need to divide the EBIT *(1- tax rate ) / required rate of return

The market value of equity = EBIT*(1-Tax) * growth rate / required rate of cost of equity - growth rate

105*.6*1.06 / .22- .06

= $417.375 million is the value of equity

Hence the market price per stock = 417.37/1 million

= $417.37

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