Question

Dabney Electronics currently has no debt. Its operating income is $20 million and its tax rate is 40 percent. It pays out all of its net income as dividends and has a zero growth rate. The current stock price is $40 per share, and it has 2.5 million shares of stock outstanding. If it moves to a capital structure that has 40 percent debt and 60 percent equity (based on market values), its investment bankers believe its weighted average cost of capital would be 10 percent. What would its stock price be if it changes to the new capital structure?

Answer 1

Operating Income = EBIT

Stock Price using DDM, P = Next Dividend / Cost of Equity

In this case dividend is constant as growth rate = 0.

WACC = weight of debt * Cost of Debt*(1-Tax rate) + Weight of Equity * Cost of Equity

Rearranging we get,

Cost of Debt = [WACC - Weight o f Debt*Cost of Debt] / [weight of debt * Cost of Debt*(1-Tax rate)]

The debt and equity values are calculated from the market values.

Total market capitalization in the no debt scenario is distributed as per the given capital structure in Case 2.