Question

The following information applies to RTC Logistics Ltd.: Operating income (EBIT) = $300,000 Shares outstanding = 120,000 shares Debt = $100,000 EPS = $1.45 Interest expense = $10,000 Stock price = $17.40 Tax rate = 40% The company is considering recapitalization where it would issue $348,000 worth of new debt and use the proceeds to buy back $348,000 worth of common stock. The buyback will be undertaken at the pre-recapitalization share price of $17.40 per share. The recapitalization is not expected to have an effect on operating income or the tax rate. After the recapitalization, the company’s total interest expense will be $50,000. Required: Assume that the recapitalization has no effect on the company’s price earnings (P/E) ratio. What is the expected price of the company’s stock following the recapitalization? Should RTC proceed with the recapitalisation exercise? Explain.

Answer 1

company’s price earnings (P/E) ratio after recapitalization = company’s price earnings (P/E) ratio before recapitalization = 17.40 / 1.45 = 12.00

The company is considering recapitalization where it would issue $348,000 worth of new debt and use the proceeds to buy back $348,000 worth of common stock. The buyback will be undertaken at the pre-recapitalization share price of $17.40 per share.

Number of shares bought back = 348,000 / 17.40 = 20,000

Number of shares outstanding after recapitalization, N = 120,000 - 20,000 = 100,000

Net income, NI = (EBIT - I) x (1 - T) = (300,000 - 50,000) x (1 - 40%) = 150,000

EPS = NI / N = 150,000 / 100,000 = 1.50

Hence, the expected price = P/E ratio x New EPS = 12 x 1.5 = $ 18.00 per share

Since the expected price = 18 > 17.40 = pre capitalization share price, RTC should proceed with the recapitalisation exercise.