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 3% per year, 250,000 shares of stock are outstanding, and the current WACC is 12.00%.

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 10% and its cost of equity will rise to 14.5%.

Explanation / Answer

D0 = 3000000*40%/250000 = 4.8 per share

g = 3%

D1 = 4.8(1.03) = 4.944

PO = D1/(Re-g)

PO = 4.944/(0.12-0.03)

PO = 54.93

NO OF SAHRES BOUGHT BACK = 3000000/54.93 = 54615 SHARES

NO OF SHARE S LEFT = 250000-54615 = 195385

AFTER RECAPITALISATION ,

DO = [{3000000-(3000000*10%*60%)} * 40%]/195285

=[{3000000- 180000}*40%]/195285

=5.78

D1 = 5.78(1.03) = 5.95

PO = D1/(Re-g)

=5.95/(0.145-0.03)

=51.74

D0 = 3000000*40%/250000 = 4.8 per share

g = 3%

D1 = 4.8(1.03) = 4.944

PO = D1/(Re-g)

PO = 4.944/(0.12-0.03)

PO = 54.93

NO OF SAHRES BOUGHT BACK = 3000000/54.93 = 54615 SHARES

NO OF SHARE S LEFT = 250000-54615 = 195385

AFTER RECAPITALISATION ,

DO = [{3000000-(3000000*10%*60%)} * 40%]/195285

=[{3000000- 180000}*40%]/195285

=5.78

D1 = 5.78(1.03) = 5.95

PO = D1/(Re-g)

=5.95/(0.145-0.03)

=51.74

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