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Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937
Textbook Problem
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RECAPITALIZATION Tartan Industries currently has total capital equal to $4 million, has zero debt, is in the 40% federal-plus-state tax bracket, has a net income of $1 million, and distributes 40% of its earnings as dividends. Net income is expected to grow at a constant rate of 3% per year, 200,000 shares of stock are outstanding, and the current WACC is 12.30%.

The company is considering a recapitalization where it will issue $2 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 10% and its cost of equity will rise to 15.5%.

  1. a. What is the stock's current price per share (before the recapitalization)?
  2. 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.

a.

Summary Introduction

To determine: The stock’s present price per share before the recapitalization.

Introduction:

Recapitalization:

The recapitalization refers to the process of changing the structure of the capital as per the requirements of a company.

Explanation

Given information:

The total capital is $4 million.

The tax rate is 40%.

The net income is $1 million.

The payout ratio is 40%.

The net income grows at 3%.

The number of shares outstanding is 200,000.

The WACC is 12.30%.

Calculation of the stock’s current price per share:

The formula to calculate the stock’s current price per share is:

Stockpricepershare=Dividendpaidpershare×(1+Growthrate)(WACCGrowthrate)

Substitute $2 for the dividend paid per share (working note), 3% for growth rate, 12.30% for WACC and 3% for growth rate in the above formula,

Stockpricepershare=$2×(1+3%)(12

b.

Summary Introduction

To determine: The stock’s current price per share after the recapitalization.

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