Question

Tartan Industries currently has total capital equal to $10 million, has zero debt, is in the 40% federal-plus-state tax bracket, has a net income of $1 million, and distributes 40% of its earnings as dividends. Net income is expected to grow at a constant rate of 3% per year, 240,000 shares of stock are outstanding, and the current WACC is 13.50%. 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)?
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.

Answer 1

A. $16.38

B. $18.70

Step-by-step explanation:

a) Calculation to determine the stock's current price per share (before the recapitalization)

Using this formula

V=D0(1+g)/K−g

Let plug in the formula

V=[(40% *$1,000,000)/240,000](1+0.03)/0.135−0.03

V=($400,000/240,000)(1+0.03)/0.135−0.03

V=1.67(1+0.03)/0.135−0.03

V=1.67(1.03)/0.135−0.03

V=1.7201/0.105

V=$16.38

Therefore the stock's current price per share (before the recapitalization) is $16.38

b. Calculation to determine what will be its stock price following the recapitalization

First step is to calculate the Interest

Interest = 1,000,000 * 11%

Interest= 110,000

Second step is to calculate the Buy back number of share

Buy back number of share = $1,000,000/16.38

Buy back number of share= 61,050 shares

Second step is to calculate the Outstanding share

Outstanding share =240,000 - 61,050

Outstanding share=178,950

Third step is to calculate the Net income

Using this formula

Net income = Income before tax -Interest - Tax

Let plug in the formula

Net income= (1666667 - 110000)* (1-0.4)

Net income= 934000.2

Fourth step is to calculate the Dividend

Dividend =934000.2 * 40%

Dividend= 373600.08

Fifth step is to calculate the Dividend per share

Dividend per share =373600.08/178950

Dividend per share= 2.088

Now let calculate the stock price after Recapitalization

Using this formula

V=D0(1+g)/K−g

Let plug in the formula

V=2.088(1+0.03)/0.145−0.03

V=2.088(1.03)/0.145−0.03

V=2.15064/0.115

V=$18.70

Therefore stock price following the recapitalization is $18.70