Intro Newcastle Inc. currently has no debt, annual earnings before interest and

Question

Intro 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 11%. 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 $39 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 8%. a. Stock price before recapitalization $57 b. What will be the debt-to-equity ratio after the recapitalization? c. What will be the cost of equity after the recapitalization? d. What will be the net income after recapitalization (in $ million)? e. What will be the stock price after the recapitalization?

Explanation / Answer

Here we are EBIT and as debt = 0. So interest expense = 0. So Net income = EBIT*(1-T) = 76 * 0.66 = $ 50.16.

(a). As the stock price before recapitalization = $57 with 8 mn shares outstanding. MArket value of equity = $ 456 mn. And as shares of $39 mn are repurchased. So the equity now = $ 417 mn and debt = $39mn. So now the D/E ratio = 0.093.

(b). Cost of equity will change and is more likely to increase. But here enough info has not been provided to calculate new cost of equity. Moreover following CAPM we get the same cost of equity of 11%. Still we can get an approximation from dividend yield of about 11.3% assuming same stock price after recap. But actually stock price will go up.

(c). After recapitalization the net income will decrease as there would be interest expense that would be reported from now on, on the debt issued. Again enough info is not thereto calculate the exact interest rate amount.Still we can say about $3.12 mn of interest expense is charged. So now the new net income = $ 48.1 mn.

(d). For new stock price we need new cost of equity = 11.3% we get the stock price from DDM. And new DPS will be 6.58 and so new stock price = 6.58 / 0.113 = 58.23. After recap.

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