Tapley Inc. currently has total capital equal to $7 million, has zero debt, is i

Question

Tapley Inc. currently has total capital equal to $7 million, has zero debt, is in the 40% federal-plus-state tax bracket, has a net income of $3 million, and pays out 40% of its earnings as dividends. Net income is expected to grow at a constant rate of 6% per year, 100,000 shares of stock are outstanding, and the current WACC is 12.20%.

The company is considering a recapitalization where it will issue $3 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 11% and its cost of equity will rise to 15.5%.

a. What is the stock's current price per share (before the recapitalization)? Round your answer to the nearest cent.

$

b. 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.

$

Thank you

Explanation / Answer

a. Current dividend = net income * payout ratio / no of shares = 3,000,000*40% / 100,000 = 12

Next year dividend = current dividend * (1+growth rate) = 12*(1+6%) = 12.72

Current price before recapitalization = next year dividend / (cost of equity-growth rate) = 12.72 / (12.2%-6%) = $ 205.16

b. Using $3 million from debt, the company can buy back shares = 3,000,000 / 205.16 = 14,622 shares

So post recapitalization, number of shares outstanding = 100,000-14,622 = 85,378 shares

Net income next year (assuming no recapitalization) = current net income * (1+growth rate) = 3,000,000*(1+6%) = 3,180,000

Assuming recapitalization, net income next year = net income assuming no recapitalization - debt * interest rate*(1-tax rate) = 3,180,000 - 3,000,000*11%*(1-40%) = 2,982,000

Dividend next year = net income next year * payout ratio / new outstanding shares = 2,982,000 * 40% / 85,378 = 13.97

Share price after recapitalization = next year dividend / (new cost of equity-growth rate) = 13.97 / (15.5%-6%) = $ 147.05

Hope this helped ! Let me know in case of any queries.

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