Tapley Inc. currently has assets of $5 million, zero debt, is inthe 40% federal-

Question

Tapley Inc. currently has assets of $5 million, zero debt, is inthe 40% federal-plus-state tax bracket, has a net income of $1million, and pays out 40% of its earnings as dividends. Netincome is expected to grow at a constant rate of 5 percent peryear, 200,000 shares of stock are outstanding, and the current WACCis 13.40%.

The company is considering a recapitalization where it willissue $1 million in debt and use the proceeds to repurchasestock. Investment bankers have estimated that if the companygoes through with the recapitalization, its before-tax cost of debtwill be 11%, and its cost of equity will rise to 14.5%.

Assuming the company maintains the same payout ratio,what will be its stock price following therecapitalization?

Explanation / Answer

$1,000,000

$400,000

200,000

$2

$2

5%

Net Income

$1,000,000

Dividend Payment ($1,000,000 *40%)

$400,000

Number of Outstanding shares

200,000

Dividend Value per share ($400,000 /200,000)

$2

Dividend Paid (D0)

$2

Dividend Growth Rate (g)

5%

After recapitalization the debt value =$1,000,000 Total Capitalization = $5,000,000 +$1,000,000 = $6,000,000 CalculatingWeighted Average Cost of Capit (WACC): WACC = (E/V)RE + (D/V) RD (1-TC) CapitalStructure: Equity          $5,000,000     Debt            $1,000,000 E/V = $5,000,000 / $6,000,000  = 0.8 D/V = $1,000,000 / $6,000,000  = 0.2 RE   = 14.5% RD   = 11% TC    = 40% WACC = 0.8 * 0.145 + 0.2* 0.11 (1-0.40) WACC = 0.116 +0.0132 WACC =0.1292(or) 12.92% Stock'sCurrent Price per share    =  D1 / (R-g) Stock'sCurrent Price per share    = D0(1+g) / (R-g) Stock'sCurrent Price per share    = $2 (1.05) /(0.1292 - 0.05) Current ShareValue   = $2.10 / 0.0792 Current ShareValue = $26.52

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