Question

Tartan Industries currently has total capital equal to $7 million, has zero debt, is in the 40% federal-plus-state tax bracket, has a net income of $2 million, and distributes 40% of its earnings as dividends. Net income is expected to grow at a constant rate of 3% per year, 400,000 shares of stock are outstanding, and the current WACC is 13.80%.

The company is considering a recapitalization where it will issue $3 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%.

1. What is the stock's current price per share (before the recapitalization)? Round your answer to the nearest cent. Do not round intermediate steps.
   $
2. 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. Round your answer to the nearest cent. Do not round intermediate steps.
   $

Answer 1

Total Capital = $7,000,000

Net Income = $2,000,000

Tax rate = 40%

Dividend Payout ratio = 40%

No. of outstanding share (before recapitalization) = 400,000

Growth rate(g) = 3%

Current WACC (Cost of equity)(ke) = 13.80%

a.

Using the Constant dividend growth model, we can calculate the Stock price with following equations -

Where,

P0 = Stock Price

Thus, Stock Price before recapitalization is $19.07

b.

Debt issued = $3,000,000

Thus,

No. of equity share outstanding after recapitalization = 400,000 - 157,315 = 242,685

Cost of Debt (Ke) = 9%

Interest expenses = 3,000,000*0.09 = $270,000

Ke = 15.5%

Thus, Share price after recapitalization is $24.96

Hope this will help, please do comment if you need any further explanation. Your feedback would be appreciated.