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)

Explanation / Answer

Dividends=20*(1-40%)=12

Dividend per share=12/2.5=4.8

Price=4.8/cost of equity

WACC=0.4*cost of debt*(1-40%)+0.6*cost of equity

0.24*cost of debt+0.6*cost of equity=0.08

Value=20*(1-0.4)/0.08=$150 million

Debt=40%*value=60 million

hence, equity=150-60=$90 million

Stock price=90/2.5=$36

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