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

Question

Question 10 - Say 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, Calculate what is the market price per share of stock?

Show calculation - hint answer is $218.75

Explanation / Answer

Number of share outstanding= 1 million

Value of debt = $300 million

Cost of debt = 12%

Tax rate = 40%

Interest payment = $300 × 12%

                            = $36 million.

EBIT = $105 million

So earning before tax = $105 - $36

                                   = $69 million.

Earning before tax = $69 million

Net profit = $69 × (1 – 40%)

                 = $41.4 million.

Net profit = $41.40 million

Earning will grow at 6% and cost of equity is 22%.

So total value of equity = $41.4 / (22% - 6%)

                                      = $258.75 million

Total value of equity is $258.75 million.

So value of share = $258.75 million / 1 million

                             = $258.75

Hence, Stock price of company is $258.75.

Related Questions

Navigate

• Browse (All)
• Browse Q
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.