Recapitalization PLEASE ROUND CORRECTLY AND FOLLOW WHAT THE PROBLEMS SAYS IN THE

ID: 2765943 • Letter: R

Question

Recapitalization PLEASE ROUND CORRECTLY AND FOLLOW WHAT THE PROBLEMS SAYS IN THE DIRECTIONS THANKS

Tapley Inc. currently has total capital equal to $7 million, has zero debt, is in the 40% federal-plus-state tax bracket, has a net income of $3 million, and pays out 40% of its earnings as dividends. Net income is expected to grow at a constant rate of 3% per year, 210,000 shares of stock are outstanding, and the current WACC is 12.20%.

The company is considering a recapitalization where it will issue $4 million in debt and use the proceeds to repurchase stock. Investment bankers have estimated that if the company goes through with the recapitalization, its before-tax cost of debt will be 10% and its cost of equity will rise to 15.5%.

What is the stock's current price per share (before the recapitalization)? Round your answer to the nearest cent.
$

Assuming that the company maintains the same payout ratio, what will be its stock price following the recapitalization? Assume that shares are repurchased at the price calculated in Part a. Round your answer to the nearest cent. Do not round intermediate steps.
$

Explanation / Answer

Solution:

Since company has no debt before recapitalization. It means company is all equity before recapitalization hence the Cost of Equity is WACC of company.

Ke = WACC = 12.20%

The stock's current price per share (before the recapitalization) --- by using dividend growth/discount model = Next Year Expected Dividend / (Ke – Growth Rate)

Next Year Expected Dividend = Next Year Income / No of shares outstanding x Payout Ratio = ($3,000,000 x 1.03) / 210,000 x 40% = $5.8857

Ke = 12.20%

Growth Rate = 3%

The Current Price of Stock (before recapitalization) = $5.8857 / (0.122 – 0.03) = $63.98

After Re-capitalization

Ke = 15.5%

Calculation of Dividend

Income before Tax ($3,000,000 / 0.60)

$5,000,000

Less: Cost of Debt ($4,000,000 x 10%)

($400,000)

Income before interest & tax

$4,600,000

Less: Tax @ 40%

($1,840,000)

Income After Tax

$2,760,000

No. of Shares outstanding (Old Share – Buy back at $63.98)

(210,000 – ($4,000,000 / 63.98)

210,000 – 62,520 = 147,480 shares

147,480

EPS

$18.714

Dividend Per Share (EPS X Dividend Payout)

($18.714 x 40%)

$7.4857

Next Year Expected Dividend ($7.4857 x 1.03)

$7.71

Current Value of Stock after recapitalization = $7.71 / (0.155 – 0.03) = $61.68