Question

Newcastle Inc. currently has no debt, annual earnings before interest and taxes of $76 million and an average tax rate of 34%. Net income is expected to stay constant forever. The firm pays out 100% of net income as dividends.

Using the CAPM, the firm estimates that its cost of equity is 13%. The risk-free rate is 2% and the expected equity market risk premium is 7%. There are 8 million shares outstanding.

The firm is considering issuing bonds worth $24 million to repurchase its own shares at the current market price. An investment bank has estimated that the coupon rate and yield to maturity on the bonds would be 5%.

1. What is the stock price before the recapitalization?

2. What will be the debt-to-equity ratio after the recapitalization?

3. What will be the cost of equity after the recapitalization?

4. What will be the net income after recapitalization (in $ million)?

5. What will be the stock price after the recapitalization?

Answer 1

1

Dividend = EBIT*(1-tax rate)/shares = 76*(1-0.34)/8=6.27

As per DDM

Price = recent dividend* (1 + growth rate )/(cost of equity - growth rate)

Price = 6.27 * (1+0) / (0.13 - 0)

Price = 48.23

2

Unlevered market value = price*shares = 48.23*8=385.84

New equity =Unlevered market value-debt = 385.84-24=361.84

debt/equity = 24/361.84=0.06632

3

Levered cost of equity = Unlevered cost of equity+D/E*( Unlevered cost of equity-cost of debt)*(1-tax rate)

Levered cost of equity = 13+0.06632*(13-5)*(1-0.34)

Levered cost of equity = 13.35

4

Net income = (EBIT-debt*interest)*(1-tax rate)

=(76-24*0.05)*(1-0.34)=49.368m

5

new shares = old shares-debt/old price = 8-24/48.23=7.502m

Dividend = net income/shares = 49.368/7.502=6.58

As per DDM

Price = recent dividend* (1 + growth rate )/(cost of equity - growth rate)

Price = 6.58 * (1+0) / (0.1335 - 0)

Price = 49.29