Question

Tartan Industries currently has total capital equal to $4 million, has zero debt, is in the 40% federal-plus-state tax bracket, has a net income of $2 million, and distributes 40% of its earnings as dividends. Net income is expected to grow at a constant rate of 5% per year, 160,000 shares of stock are outstanding, and the current WACC is 12.10%.

The company is considering a recapitalization where it will issue $4 million in debt and use the proceeds to repurchase stock. Investment bankers have estimated that if the company goes through with the recapitalization, its before-tax cost of debt will be 9% and its cost of equity will rise to 14.5%.

a. What is the stock's current price per share (before the recapitalization)? Round your answer to the nearest cent. Do not round intermediate steps _________. $

Assuming that the company maintains the same payout ratio, what will be its stock price following the recapitalization? Assume that shares are repurchased at the price calculated in part a. Round your answer to the nearest cent. Do not round intermediate steps. ___________ $

Answer 1

The formula for WACC is

WACC=E/V​∗Re+D/V​∗Rd∗(1−Tc)​

• Re = cost of equity
• Rd = cost of debt
• E = market value of the firm's equity
• D = market value of the firm's debt
• V = E + D = total market value of the firm’s financing (equity and debt)
• E/V = percentage of financing that is equity
• D/V = percentage of financing that is debt
• Tc = corporate tax rate

Since D is zero before recapitalization.

Net income is 2 Million

Dividend is 40% of Net Income 800,000 $

Earnings net of Dividend

2 Mill - 800k $ = 1.2 Million USD.

40% of Tax deducted = 480k USD

Total Market value of share = 4 + 2 = 6 Million USD

Total shares oustanding = 160000

Share price = 6 Million/160000 = 37.5 USD.

1.2 Mill - 480k 720k $ is Net Income

Stock Price = Dividends (Div) / (Expected Return (R) - Dividend Growth Rate (G))