Tartan Industries currently has total capital equal to $9 million, has zero debt

Question

Tartan Industries currently has total capital equal to $9 million, has zero debt, is in the 40% federal-plus-state tax bracket, has a net income of $4 million, and distributes 40% of its earnings as dividends. Net income is expected to grow at a constant rate of 5% per year, 120,000 shares of stock are outstanding, and the current WACC is 12.60%. The company is considering a recapitalization where it will issue $4 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%. What is the stock's current price per share (before the recapitalization)? Round your answer to the nearest cent. Do not round intermediate steps. $ 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

Given Net income is $4 M (Assumed after tax) and dividend is 40% of the net income i.e $1.6 M now dividend payment ratio will be Total dividend/no of shares = $1.6 M/1.2M = i.e $1.33 per share .

Also given Current WACC is 12.60% , the formula for WACC is = Cost of equity * Equity/total capital+ cost of debt *debt/total capital

Which means 12.60= Cost of equity * $9M/$9M + Cost of debt * zero (as company has no debt)

Solving we get cost of equity = 12.60%

We also know Cost of equity = (Dividend payment in coming years/ Current price of share) + Growth rate of dividend

Dividend payment in second year is( Net income in coming year * % of dividend payment )/no of shares (assuming recapitalisation doesnot take place because we cannot calculate no of shares if we consider recapitalization as it is totally dependent on current market price , which is also not given

Dividend for secodn year is = $4.2 Million*40%/1.20M shares = $1.4 per share

Putting variables in cost of equity formula

12.60% = (Rs1.40 per share/ Price )+ (1.40-1.33)/1.33 (growth rate of dividend)

solving we get Current price of share = 11.52

For Stock price after recapitalisation is as under

We know cost of equity formul = (Di for next year/current market price)+Growth rate of dividend

Given Dividend payout ratio will remain same after recapitalisation so D1 wil remain as 1.40 per share and growth rare as zero

Putting numbers in formula we ger

14.50% = (1.40/Market price )+ zero

Solving we get market price after recapitalization as $9.66

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