Tapley Inc. currently has total capital equal to $6 million, has zero debt, is i

Question

Tapley Inc. currently has total capital equal to $6 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, 200,000 shares of stock are outstanding, and the current WACC is 12.90%.

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 14.5%.

Explanation / Answer

WACC = 12.90%

Dividend paid = 4000000 * 0.40 = 1600000

Dividend per share = 1600000/200000 = 8

Next year didvidend = 8 * (1.05) = 8.40

price per share = 8.40/(0.129-0.05) = 106.33

EBIT before capitilization = 4000000/(1-0.4) = 6666666.67

net income after capitilization = (6666666.67 - (0.11 * 6666666.67) ) * 0.6 = 3560000

number of shares outstanding = 200000 - (4000000/106.33) = 162381

Do = 0.4 * (3560000/162381) = 8.769

D1 = 8.769 * 1.05 = 9.20745

after recapitilization Po = 9.20745/(0.145-0.05) = 96.92

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