Question

Tapley Inc. currently has total capital equal to $5 million, has zero debt is in the 40% federal-plus-state tax bracket, has a net income of $1 million and pays out 40% of its earnings as dividends. Net income is expected to grow at a constant rate of 5% per year, 200000 shares of stock are outstanding and the current WACC is 13.40%

The company is considering a recapitalization where it will issue $1 million un 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 11% and its cost of equity will rise to 14.5%.

assuming that the company maintains the same payout ratio, what will be its stock price after recapitalisation?

Answer 1

Tapley Inc has 5 million capital without any debt
The company's WACC is 13.40%
Since there is only equity in the capital structure WACC= Cost of Equity = 13%
Net Income after tax	1,000,000.00
Dividend Pay out 40%	400,000.00
No of Shares outstanding	200000
Dividend per share	2.00
Cost of Equity	13.40%
Growth Rate	5%
Share price	23.81	Dividend per share/ (Cost of Equity - Growth Rate)
Now the company raises debt to repurchase the stock
Amount of Debt	1,000,000.00
No of shares bought back	42000	( Amount of debt / share price)
Outstanding shares	158000
Net Income after tax	1,050,000.00	With growth of 5%
Less: After tax Cost of debt	(66,000.00)
Earning available for equity	984,000.00
Dividend payout	393,600.00	i.e 40%
Dividend per share	2.49	(393600/158000)
Growth Rate	5%
Increased cost of Equity	14.50%
Revised share price	26.22	Stock price after recapitalisation