Question 5 Frontier Motors is an all-equity firm with 200,000 shares outstanding
ID: 2807693 • Letter: Q
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Question 5 Frontier Motors is an all-equity firm with 200,000 shares outstanding. The company's EBIT is RM2,000,000.00 and EBIT is expected to remain constant over time. The company pays out all of its earnings each year, so its earnings per share equal its dividends per share. The company's tax rate is 40%. The company is considering issuing RM2,000,000.00 worth of bonds (at par) and using the proceeds for a stock repurchase. If issued, the bonds would have an estimated yield to maturity of 10%. The risk-free rate in the economy is 6.6% and the market risk premium is 6%. The company's beta is currently 0.90 but its investment bankers estimate that the company's beta would raise to 1.10 if it proceeds with the recapitalization. Assume that the shares are repurchased at a price equal to the stock market price prior to the recapitalization. What would be the company's stock price following the recapitalization?Explanation / Answer
1)Calculation of before recapitalisation price :
Earning after tax = [EBIT-interest][1-tax]
= [2,000,000-0][1-.40]
= 2,000,000*.60
= 1,200,000
cost of equity = Risk free rate +[market premium*beta]
= 6.6+[6*.9]
= 6.6+ 5.4
= 12%
value of firm = Earning after tax /cost of equity
= 1,200,000/.12
= $ 10,000,000
price per share = 10,000,0000/200000= $ 50 per share
2)Number of shares repurchased : bond issued /price before recapitalisation
= 2,000,000/50
= 40,000shares
shares outstanding after repurchase = 200000-40000=160000
3)cost of equity after repurchase = 6.6+[6*1.1]
= 6.6+6.6
= 13.2%
Interest on bond = 2000000*.10 = 200,000
Earning after tax = [2000000-200000][1-.40]
= 1,800,000*.60
= 1,080,000
Value of firm = 1,080,000/.132
= $ 8,181,818.18
value of equity : 8,181,818.18-2,000,000 debt = 6,181,818.18
price per share post recapitalisation = 6,181,818.18 /160000
= $ 38.64 per share
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