Question

Monroe Inc. is an all-equity firm with 500,000 shares outstanding. It has $2,000,000 of EBIT, and EBIT is expected to remain constant in the future. The company pays out all of its earnings, so earnings per share (EPS) equal dividends per share (DPS), and its tax rate is 40%. The company is considering issuing $4,500,000 of 9.00% bonds and using the proceeds to repurchase stock. The risk-free rate is 4.5%, the market risk premium is 5.0%, and the firm's beta is currently 1.10. However, the CFO believes the beta would rise to 1.30 if the recapitalization occurs. Assuming the shares could be repurchased at the price that existed prior to the recapitalization, what would the price per share be following the recapitalization? (Hint: P₀ = EPS/r_s because EPS = DPS.)

a. $29.51

b. $21.44

c. $27.84

d. $28.12

Answer 1

EPS before recapitalization = EBIT(1-Tax)/Number of shares

= 2,000,000*(1-40%)/500,000

= $2.4 per share

Required return as per CAPM = risk free rate + beta*market risk premium

= 4.5% + 1.10*5%

= 10%

Share price = DPS/Required return

= 2.4/10%

= $24

Number of share repurchased = 4,500,000/24

= 187,500 shares

Shares after recapitalization = 500,000-187,500 = 312,500 shares

Required return = 4.5%+1.3*5%

= 11%

EPS or DPS = (2,000,000 – 4,500,000*9%)(1-40%)/312,500

= $3.0624

Price per share = 3.0624/11%

= $27.84

Hence, the answer is c.