Question

Dabney Electronics currently has no debt. Its operating income (EBIT) is $20 million and its tax rate is 40 percent. It pays out all of its net income as dividends and has a zero growth rate. It has 2.5 million shares of stock outstanding. If it moves to a capital structure that has 40 percent debt and 60 percent equity (based on market values), its investment bankers believe its weighted average cost of capital would be 10 percent. What would its stock price be immediately after issuing debt if it changes to the new capital structure?

(Hint: Find value of the firm after capitalization using Va = FCF1/(WACC-g), and then calculate price of the stock using P0 = [S + (D – D0) ] / n0)

Answer 1

Currently the Debt is 0 and the equity is 100%

After moving to new capital structure

Currently the Debt is 40 and the equity is 60%

The growth rate = 0%

The tax rate = 40%

Number of shares outstanding = 2.5 Million

WACC = 10% , EBIT = 20 Mn

FCF1 = EBIT ( 1 - tax rate )

The value Va = FCF1/(WACC-g)

=

=

=

= 120 Million

The price of the stock = Value/no of shares outstanding

= 120/2.5 = 48 $