Dabney Electronics currently has no debt. Its operating income (EBIT) is $30 mil

Question

Dabney Electronics currently has no debt. Its operating income (EBIT) is $30 million and its tax rate is 40 percent. It pays out all of its net income as dividends and has a zero growth rate. It has 2.5 million shares of stock outstanding. If it moves to a capital structure that has 40 percent debt and 60 percent equity (based on market values), its investment bankers believe its weighted average cost of capital would be 8 percent. What would its stock price be immediately after issuing debt if it changes to the new capital structure?

(Hint: Find value of the firm after capitalization using Va = FCF1/(WACC-g), and then calculate price of the stock using P0 = [S + (D – D0) ] / n0)

$90

$200

$60

$72

$48

$90

$200

$60

$72

$48

Explanation / Answer

EBIT $       30,000,000 Tax Rate 40% FCF1 = EBIT x (1-Tax rate) - (Capital expenditure - depreciation) - Change in non cash Working capital $       18,000,000 WACC 8% Firm value $     225,000,000 New structure Equity = Value of the firm x .60 $     135,000,000 Debt = Value of the firm x .40 $       90,000,000 Number of share outstanding              2,500,000 $                   7.20 135000000 / 2500000 $                 54.00 7.20 / 1.08 $                   6.00 54+6 $                 60.00

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