Question

Tartan Industries currently has total capital equal to $9 million, has zero debt, is in the 40% federal-plus-state tax bracket, has a net income of $4 million, and distributes 40% of its earnings as dividends. Net income is expected to grow at a constant rate of 3% per year, 440,000 shares of stock are outstanding, and the current WACC is 12.40%. The company is considering a recapitalization where it will issue $5 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 9% and its cost of equity will rise to 15.5%. a. What is the stock's current price per share (before the recapitalization)? Do not round intermediate calculations. Round your answer to the nearest cent. b. 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. Do not round intermediate calculations. Round your answer to the nearest cent.

Answer 1

a) Using dividend growth model, Price (P) DO x (1 + g) (r - g) Where 4m x 40% / 440,000 = $3.64 Current dividend (D0) g-growth rate 3%, r-required rate 12.40% Price (P) 3.64 x (1 4%) / (12.4% - 3%) = $ 40.27

b) Before debt, Net Income / (1 - tax rate) 4m / (1 - 40%) $6,666,667 EBIT With debt, (6,666,667 - 5,000,000 x 9%) x (1 - 40%) = $3,730,000 Net Income (EBIT Interest) x (1 - tax rate) 5m /$40.27 = 124,162 shares Shares Repurchased New outstanding shares 440,000 124,162 315,838 DO 3,730,000 x 40% / 315,838 shares $ 4.72394075 Price, P 4.72394075 x (1 +4%) (15.5% - 4%) $ 42.72