Question

Boston Cube Inc. currently has no debt, annual free cash flows of $52 million and an average tax rate of 34%. Free cash flows are expected to grow by 7% per year forever.

Using the CAPM, the firm estimates that its cost of equity is 12%. The risk-free rate is 2% and the expected equity market risk premium is 7%. There are 8 million shares outstanding.

The firm is considering a new capital structure with a debt-to-capital ratio of 50%. The company would issue bonds to repurchase its own shares at the current market price. An investment bank has estimated that the yield to maturity on the company's bonds would be 6%.

1.) What is the stock price before the recapitalization?

2.) What will be the WACC after the recapitalization?

3.) What will be the stock price after the recapitalization?

Answer 1

(1) Annual Free Cash Flow (FCF) = $ 52 million , FCF Growth Rate = 7 % and Cost of Equity = 12 %

Therefore, Firm Value = (52 x 1.07) / (0.12 - 0.07) = $1112.8 million

Number of Shares Outstanding = 8 million

Price per Share Prior to Recapitalization = 1112.8 / 8 = $ 139.1

(2) Target Capital Structure = 50% , Debt to Equity Ratio = DE Ratio = 1, Tax Rate = 34 %

Unlvered Cost of Equity = 12 % and Cost of Debt = 6 %

Let the levered cost of equity be R

Therefore, R = 12 + (12-6) x (1) x (1-0.34) = 15.96 %

WACC = 15.96 x 0.5 + 6 x (1-0.34) x 0.5 = 9.96 %

(3) let the debt raised be D and the subsequent interest tax shield generated be (D x 0.34 x 0.06) / 0.06 = 0.34D $

Therefore, [D/(1112.8 + 0.34D)] = 0.5

D = 556.4 + 0.17D

D = 556.4 / (1-0.17) = $ 670.361 million

Value of Interest Tax shied = 0.34 x 670.361 = $ 227.923 million

New Firm Value post Recapitalization Annoucement = 1112.8 + 227.923 = $ 1340.72 million

Stock Price Post Recapitalization = 1340.72 / 8 = $ 167.59