Question

Current Information (All Equity firm)
Common stock outstanding 100,000 shares
EBIT $200,000
Tax 40%
Dividend policy 100% payout ratio
Cost of equity:
Risk-free rate 3.00%
Market return 12.00%
Stock Beta 1.10
Recapitalization Exercise:
Company to issue $100,000 bonds with 10% interest and proceeds use to retire common stock. Assume market is in equilibrium, stocks can be repurchased at pre-recapitalization price. What is the price after re-capitalization?

Answer 1

As per CAPM

expected return = risk-free rate + beta * (expected return on the market - risk-free rate)

Expected return% = 3 + 1.1 * (12 - 3)

Expected return% = 12.9

Current share price = (EBIT*(1-tax rate)/cost of equity)/share outstanding

=(200000*(1-0.4)/0.129)/100000=9.302

Share repurchased = debt/share price= 100000/9.302=10750.3763

New firm value = (EBIT-interest%*debt)*(1-tax rate)/cost of equity)

=(200000-0.1*100000)*(1-0.4)/0.129)=883720.93

New share price = New firm value/(Old shares-shares repurchased)

=883720.93/(100000-10750.3763)

=9.901