Tapley Inc. currently has assets of $5 million, zero debt, is in the 40% federal-plus-state tax bracket, has a net income of $1 million, and pays out 40% of its earnings as dividends. Net income is expected to grow at a constant rate of 5 percent per year, 200,000 shares of stock are outstanding, and the current WACC is 13.40%.
The company is considering a recapitalization where it will issue $1 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%.
Assuming the company maintains the same payout ratio, what will be its stock price following the recapitalization?
Step 1: Calculate EBIT before the recapitalization:
EBIT = $1,000,000/(1 – T) = $1,000,000/0.6 = $1,666,667.
Note: The firm is 100% equity financed, so there is no interest expense.
Step 2: Calculate net income after the recapitalization:
[$1,666,667 – 0.11($1,000,000)]0.6 = $934,000.
Step 3: Calculate the number of shares outstanding after the recapitalization:
200,000 – ($1,000,000/$25) = 160,000 shares.
Step 4: Calculate D1 after the recapitalization:
D0 = 0.4($934,000/160,000) = $2.335.
D1 = $2.335(1.05) = $2.45175.
Step 5: Calculate P0 after the recapitalization:
P0 = D1/(rs – g) = $2.45175/(0.145 – 0.05) = $25.8079 » $25.81.
