Question

Merriwether Building has operating income of $20 million, a tax rate of 40%, and no debt. 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% debt and 60% equity (based on market values), its investment bankers believe its weighted average cost of capital would be 10%. What would its stock price be if it changes to the new capital structure

Answer 1

Answer: $48.00

Step-by-step explanation:

First find the value of the firm:

= After tax income / WACC

= ( 20,000,000 * (1 - 40%)) / 10%

= $120,000,000

Then find the value of equity and debt given the new capital structure:

Equity:

= 120,000,000 * 60%

= $72,000,000

Debt

= 120,000,000 * 40%

= $48,000,000

Given the above, find the stock price with:

= (Value of Equity + Value of debt) / Number of shares outstanding

= (72,000,000 + 48.000,000) / 2.5 million

= $48.00