Question

Powell Plastics, Inc. (PP) currently has zero debt. Its earnings before interest and taxes (EBIT) are $80,000, and it is a zero growth company. PP’s current cost of equity is 10%, and its tax rate is 40%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $48.00. Assume that PP is considering changing from its original capital structure to a new capital structure with 35% debt and 65% equity. This results in a weighted average cost of capital equal to 9.4% and a new value of operations of $510,638. Assume PP raises $178,723 in new debt and purchases T-bills to hold until it makes the stock repurchase. PP then sells the T-bills and uses the proceeds to repurchase stock. How many shares remain after the repurchase, and what is the stock price per share immediately after the repurchase?

Answer 1

How many shares remain after the repurchase, and what is the stock price per share immediately after the repurchase?

• 6,500 stocks remaining at $64.33 each stock

Step-by-step explanation:

EBIT $80,000

zero growth rate

Cost of equity (Re) 10%

tax rate 40%

10,000 common stocks outstanding at $48

they want to change from 100% equity to 35% debt and 65% equity

WACC = 9.4%

new value of operations $510,638

PP's value of operations = {$80,000 x (1 - 40%)} / WACC = $510,638

the new stock price should = $510,638 / 10,000 stocks = $51.06

Stock price will be $51.06

approximately $178,723 / $51.06 = 3,500 stocks should be repurchased

9.4% = ($480,000/$658,723 x 10%) + ($178,723/$658,723 x cost of debt x (1 - 40%)

9.4% = 7.29% + ($178,723/$658,723 x cost of debt x (1 - 40%)

2.11% = 0.2713 x cost of debt x 0.6

2.11% = 0.1628 x cost of debt

cost of debt = 2.11%/0.1628 = 12.96%

new WACC = ($178,710/$357,433 x 10%) + ($178,723/$357,433 x 12.96% x 0.6) = 5% + 6.48% = 11.48%

PP's value of operations = {$80,000 x 0.6} / 11.48% = $418,118

the new stock price should = $418,118 / 6,500 stocks = $64.33