Question

Trivoli Inc. is an all-equity firm with 1,000,000 shares outstanding. The company's EBIT is $2,500,000, and EBIT is expected to remain constant over time. The company pays out all of its earnings each year, so its earnings per share (EPS) equals its dividends per share (DPS). The company's tax rate is 25%. The company is considering issuing $3.25 million worth of bonds (at par) and using the proceeds for a stock repurchase. If issued, the bonds would have an estimated YTM of 5%. The risk-free rate is 3%, and the market risk premium is 5.5%. The company's beta is currently 0.90, but investment bankers say the beta will rise to 1.0079 if the recapitalization occurs. 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? $21.00 $22.65 $23.80 $24.25 $25.00

Answer 1

under CAPM Cost of Equity = Rf + B (Pm -R4) where R = Risk free rate B = beta Rm- Rf = market risk Premium so Cost of Equity = 3 + 0.9 (5.5) = 7.95% Earning per share - Dividend per shave (pay out = 100%) so EPS = EBIT (1- tax) number of shares out Standing 2500 000 (1-0-25) 1 000 000 we now dividend = to have 1.875 calculate Dividend Price = Price using above 1.815 - = 23-5849 - 7.951 - 7.95% cost of Equity so number of shares to be repurchased Bonds issued price of STOCK 3,250,000 23.5849 = 137,800 shares

before above Calculations are all re Capitalisation I now after recapitalisation :- new Beta= 1.0079 I so Cost of Equity = 3+1:0019 (5.5) = 8.54345% Interest rate on Bonds= 5% so Interest = 3250000 x 5% = 162500 new DPs= E.P.S = (EBIT - Interest) (1-Tax) shares Outstanding number of shares outstanding after Bonds issue: 1000 000 - 13T800 = 862,200 D.P.S= 2500000 - 162500) (1-0-25) 862,200 = 2.0333 So STOCK Price = 2.0333 8.54345 % = $23.80 / [ NOTE: when at bonds issued at par and par YTM = Couponrate = 517 redeeme