RECAPITALIZATION Tartan Industries currently has total capital equal to $5 milli
ID: 2791836 • Letter: R
Question
RECAPITALIZATION Tartan Industries currently has total capital equal to $5 million, has zero debt, is in the 40% federal-plus-state tax bracket. has a net income of $2 million, and distributes 40% of its earnings as dividends. Net income is expected to grow at a constant rate of 3% per year, 350,000 shares of stock are outstanding, and the current WACC is 13.00%. The company is considering a recapitalization where it will issue $2 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 9% and its cost of equity will rise to 14.5%. a. What is the stock's current price per share (before the recapitalization)? Round your answer to the nearest cent. Do not round intermediate steps. b. 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
Current Dividends=2*40%=0.8 million
Dividend per share=0.8*10^6/350000=2.285714
Expetced dividend=2.285714*(1+3%)=2.354285
As it is zero debt company, WACC is cost of equity
Price of stock=Expected dividend/(cost of equity-growth rate)=2.354285/(13%-3%)=23.54285
2
As no debt is there, so no interest and hence Net Income=EBIT*(1-tax rate)
Hence, EBIT before recapitalization=Net income/(1-tax rate)=2/(1-40%)=3.33 million
Interest=2*9%=0.18 million
Net Income=(3.33-0.18)*(1-40%)=1.89 million
Number of shares outstanding after recpaitalization=350000-2000000/23.54285=265048.5
Dividends after recapitalization=0.4*1.89*10^6/265048.5=2.852308
Expected dividends=2.852308*1.03=2.937877
Price after recapitalization=2.937877/(14.5%-3%)=25.54676
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