Question 10 - Say you decide to start a firm and you need $500 million of capita

Question

Question 10 - Say you decide to start a firm and you need $500 million of capital to begin. You sell stock for its par value, a total of one million shares (par value is $200 per share), and sell $300 million of bonds at par value. You use the capital you just raised to buy $500 million of equipment. Assume that the average cost of capital = 12%. In the first year of operation, EBIT = $105 million, tax rate 40% and the required rate of return on equity is 22%. Assume that the market expects that the firm will continue to grow its Economic Profit at a rate of 6% annually, what is the market price per share of stock?

Explanation / Answer

Value of firm = EBIT x (1-t)/(R-g)

                      =105 x(1-0.40)/ (0.12-0.06)

                      = 1050 million

Value of equity = value of firm – debt

                        = 1050 million – 300 million

                        = 750 million

Price per share = value of equity / no. of shares

                        = 750 million / 1 million

                        = 750 per share

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