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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, it’s 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? (Points: 8) After recapitalization: EBIT 1,000,000
Less Interest (1,000,000*11%*0.6) -66000 Net income available to shareholders 934,000
Number of shares outstanding after the recapitalization:
200,000 – (1,000,000/25) = 160,000 shares
Dividend after recapitalization = 934,000 x 40% = $373,600
Dividend per share = 373,600/160,000 = 2.335
D1 = D0 (1 + g) = 2.335 (1 + 0.05) = 2.45175
P 0 = 2.45175/ (14.5% - 5%) = $25.81
Firms A and B are identical except for their level of debt and the interest rates they pay on debt. Each has $2 million in assets, $400,000 of EBIT, and has a 40% tax rate. However, firm A has a debt-to-assets ratio of 50% and pays 12% interest on its debt, while Firm B has a 30% debt ratio and pays only 10% interest on its debt. What is the difference between the two firms' ROEs?
(Points: 4) 1.25% 1.91% 2.23% 2.64% 2.86% Differences in ROE
Assets$2,000,000
EBIT$400,000
Tax rate40%
Firm A debt ratio50%
Firm A interest rate12%
Firm B debt ratio30%
Firm B interest rate10%
Firm A net income$168,000
Firm A equity$1,000,000
Firm A ROE16.8%
Firm B net income$204,000
Firm B equity$1,400,000
Firm B ROE14.57%
ROE