10)

RECAPITALIZATION

A company currently has total capital equal to $5m, has zero debt, is in the 40% tax bracket, has a net income of $1m, and distributes 40% of its earnings as dividends. Net income is expected to grow at a constant rate of 5% 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 $1m 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%.

a) What is the stock's current price per share (before the recapitalization)?

P0 = DPS / rsDividends = DPS =

P0 = DPS / rsP0 =

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.

NO DEBTDEBT

EBITEBIT

Shares repurchased =

IntInt

Dividends =

EBTEBTDPS =

TaxTaxP0 =

Net IncomeNet IncomeP0 =