Old Exam Questions - Capital Structure and Leverage - Solutions
Page 38 of 59 Pages
New EPS = $9,288 / 1,759.26 = $5.28
New Price = $5.28 / .18 = $29.33
Increase in Price = $29.33 - $27.00 = $2.33
39.
Assume that your company is an all-equity firm with 250,000 shares outstanding. The
company’s EBIT is $2,500,000, and EBIT is expected to remain constant over time.
The company pays out all of its earnings each year, so its earnings per share are
equal to its dividends per share and this is currently $6.00 per share. The company’s
tax rate is 40 percent, its current cost of stock, K
S
, is 8 percent, and its current stock
price is $75 per share.
Now assume that the company is considering issuing $3.75 million worth of bonds (at
par) and using the proceeds for a stock repurchase. If issued, the bonds would have
an estimated yield to maturity of 5 percent or interest of $187,500. The risk-free rate in
the economy is 4 percent, and the market risk premium is 5 percent. The company’s
beta is currently 0.8, but its investment bankers estimate that the company’s beta
would rise to 0.9 if it proceeds with the recapitalization.
Assume that the shares are repurchased at a price equal to the stock market price
prior to the recapitalization (that is, the market does not anticipate
any change in
price). Given this information, determine the price of the company’s stock after the
recapitalization has been completed.
A.
$80.29
*
B.
$81.62
C.
$76.43
D.
$83.08
E.
$78.81
First, find the company’s current cost of capital, dividends per share, and stock price:
K
s
= 0.04 + (0.05)(0.8) = 8.0%
DPS = ($2,500,000)(1 - 0.4) / (250,000) = $6.00
P
0
= $6.00 / 0.08 = $75.00
Alternatively,
Value = ($2,500,000)(1 - 0.4) / 0.08 = $18,750,000
P
0
= $18,750,000 / 250,000 = $75.00
Therefore,
Shares repurchased = $3,750,000 / $75 = 50,000