Question

Tartan Industries currently has total capital equal to $4 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 6% per year, 190,000 shares of stock are outstanding, and the current WACC is 12.80%.

The company is considering a recapitalization where it will issue $1 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 14.5%.

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

B.) 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. Do not round intermediate calculations. Round your answer to the nearest cent.

Answer 1

Before capitalization
Particulars			amount
net income			2000000
no of share			190000
Earning per share= net income/no of share
Earning per share = 2000000/190000 = 10.52
Dividend per share = EPS*payout ratio
dividend per share = 10.52*40%
Dividend per share = 4.208
price of share = Dividend*(1+growth)/cost of equity-growth
price of share = 4.208*(1+0.06)/(0.128-0.06)
price per share = 66
After recapitalization
No of share can purchase = net proceed from debt/share price
no of share can purchase = 1000000/66 = 15152
share outstanding = 190000-15152 = 174848
Net income			2000000
less: interest cost(1000000*11%)*0.60			66000
net income			1934000
dividend @40%			773600
Dividend per share = dividend/no of share
dividend per share= 773600/174848 = 4.4244
price of share = dividend*(1+growth)/cost of equity-growth
price of share = 4.4244*(1+6%)/(14.5%-6%)
price per share = 55