Question

Tartan Industries 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 $4 million, and distributes 40% of its earnings as dividends. Net income is expected to grow at a constant rate of 5% per year, 220,000 shares of stock are outstanding, and the current WACC is 13.70%.

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 11% and its cost of equity will rise to 16.5%.

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

a). Net income = $4 million

Payout ratio = 40%

Dividend, D0 = 0.40 x $4 million = $1,600,000

DPS = $1,600,000/220,000 = $7.27

g = 5%

Current WACC or Ke = 13.7% (Since there's no debt, Ke is the WACC)

By Dividend discount formula, P0 = D0(1+g)/Ke-g. Therefore,

P0 = $7.27(1+0.05)/(0.137 - 0.05) = $7.64 / 0.087 = $87.77

b). Step1: Calculate EBIT before the recapitalization:

EBIT = $4,000,000/(1 - T) = $4,000,000/0.6 = $6,666,667.

Note: The firm is 100% equity financed, so there is no interest expense.

Step 2: Calculate net income after the recapitalization:

($6,666,667 - 0.11($2,000,000))(1 - 0.4) = $3,868,000.

Step 3: Calculate the number of shares outstanding after the recapitalization:

220,000 - ($2,000,000/$87.77) = 197,213 shares.

Step 4: Calculate D1 after the recapitalization:

D0 = 0.4($3,868,000/197,213) = $7.85

.D1 = $7.85(1.05) = $8.24.

Step 5: Calculate P0 after the recapitalization:

P0 = D1/(Ke - g) = $8.24/(0.165 - 0.05) = $71.63