Dabney Electronics currently has no debt. Its operating income (EBIT) is $20 mil

Question

Dabney Electronics currently has no debt. Its operating income (EBIT) is $20 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)

$200

$60

$90

$72

$48

$200

$60

$90

$72

$48

Explanation / Answer

b. $60

EBIT = 20 million

Less tax = 40%*20 = 8 million

Profit after tax = 12 million

This is given out as dividend

Value of the firm = FCF/ (WACC-g)

= 12 million/ 8%

= 150 million

Current price of stock = 150/ 2.5 = $60 per share

Required debt = 150million*40% = 60 million

Share buyback = 60 million/ 60 = 1 million shares

New outstanding shares in the market = 2.5 -1 = 1.5 million

Value of equity = 150*60% = 90 million

Hence New share price = 90/ 1.5 = $60

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