Question

Tartan Industries currently has total capital equal to $9 million, has zero debt, is in the 25% 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, 390,000 shares of stock are outstanding, and the current WACC is 13.60%.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%.
a. What is the stock's current price per share (before the recapitalization)?
b. Assuming that the company maintains the same payout ratio, what will be its stock price following the recapitalization?

Answer 1

Answer:

a.$28.97

b.$23.12

Explanation:

The share price can be computed using the below formula:

Share price=do*(1+g)/r-g

do is the dividend paid now

g is the dividend growth

r is the current WACC which is the same as the cost of equity since there is no debt.

do=$2,000,000*40%/390,000=$ 2.05  

g is 6%

WACC is 13.50%

Share price=$2.05*(1+6%)/(13.50%-6%)=$28.97

When recapitalization happens:

First we need to determine the earnings before interest and tax,then net income in order to determine the dividend per share

EBIT=$2,000,000/(1-tax rate)=$2,000,000/(1-0.25)=$ 2,666,666.67  

less interest expense($2,000,000*11%)                  =($220,000)

Earnings before tax                                                    = 2,446,666.67  

income tax expense ( 2,446,666.67*25%)                 =($611,666.67)

net income                                                                   =$ 1,835,000.00  

Number of shares after recapitalization =390,000-($2,000,000/$28.97)=320963  shares

Since the share repurchase would be at the earlier calculated market price of $28.97

Dividend per share=$1,835,000.00*40%/320963 =$2.29

new cost of equity is 16.5%

share price =$2.29*(1+6%)/(16.5%-6%)=$23.12