Tapley Inc. currently has total capital equal to $10 million, has zero debt, is

Question

Tapley Inc. currently has total capital equal to $10 million, has zero debt, is in the 40% federal-plus-state tax bracket, has a net income of $4 million, and pays out 40% of its earnings as dividends. Net income is expected to grow at a constant rate of 5% per year, 240,000 shares of stock are outstanding, and the current WACC is 12.20%.

The company is considering a recapitalization where it will issue $5 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%.

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

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.
$  

Tapley Inc. currently has total capital equal to $10 million, has zero debt, is in the 40% federal-plus-state tax bracket, has a net income of $4 million, and pays out 40% of its earnings as dividends. Net income is expected to grow at a constant rate of 5% per year, 240,000 shares of stock are outstanding, and the current WACC is 12.20%.

The company is considering a recapitalization where it will issue $5 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%.

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

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.
$  

Explanation / Answer

(1) Before recapitalization

Cost of equity = (Next period dividend / current share price) + growth rate

Here, cost of equity = 12.2% (Since firm has zero debt)

Current dividend = Net income x 40%

= $4 mill x 40% (Net income is post-tax)

= $1.6 mill

Next year dividend = $1.6 mill x 1.05 = $1.68 mill

Dividend per share = $1.68 mill / 0.24 mill = $7

So

0.122 = ($7 / Stock price) + 0.05

Solving,

Stock price = $97.22

(2) After recapitalization

Number of shares repurchased = $5,000,000 / $97.22 = 51,430

So number of outstanding shares will decrease by 51,430 to 188,570.

Next-period dividend per share = $4 million x 40% x 1.05 / 188,570 = $8.91

Hence

0.155 = ($8.91 / stock price) + 0.05

Stock price = $84.86

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