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United Producers (UP), an unleveraged firm, has a total market value of $10 million, consisting of 500,000 shares of common stock selling at $20 per share. Management is considering recapitalizing by issuing enough debt so that the firm has a capital structure consisting of 20 percent debt (based on market values) at a before-tax cost of 10 percent. UP will use the proceeds to repurchase stock at the new equilibrium market price. UP’s marginal tax rate is 40 percent. It has earnings before interest and taxes (EBIT) of $2 million; it expects zero growth in EBIT, and it pays out all earnings as dividends.

e. What is its new weighted average cost of capital?
f. What is the new total corporate value of UP?
g. What is the new stock price?
h. How many shares remain outstanding after the recapitalization?

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Jean Keeling
Jean KeelingLv2
28 Sep 2019

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United Producers (UP), an unleveraged firm, has a total market value of $10 million, consisting of 500,000 shares of common stock selling at $20 per share. Management is considering recapitalizing by issuing enough debt so that the firm has a capital structure consisting of 20 percent debt (based on market values) at a before-tax cost of 10 percent. UP will use the proceeds to repurchase stock at the new equilibrium market price. UP’s marginal tax rate is 40 percent. It has earnings before interest and taxes (EBIT) of $2 million; it expects zero growth in EBIT, and it pays out all earnings as dividends.

Dabney Electronics currently has no debt. Its operating income(EBIT) is $30 million and its tax rate is 40 percent. It pays outall of its net income as dividends and has a zero growth rate. Ithas 2.5 million shares of stock outstanding. If it moves to acapital structure that has 40 percent debt and 60 percent equity(based on market values), its investment bankers believe itsweighted average cost of capital would be 10 percent. What wouldits stock price be immediately after issuing debt if it changes tothe new capital structure?

Hint: Find value of the firm after capitalization using Va =FCF1/(WACC-g), and then calculate price of the stock using P0 = [S+ (D – D0) ] / n0)

a.

$90
b.

$60
c.

$48
d.

$200
e.

$72

RAK, Inc., has no debt outstanding and a total market value of $360,000. Earnings before interest and taxes, EBIT, are projected to be $24,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 25 percent higher. If there is a recession, then EBIT will be 40 percent lower. The company is considering an $100,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,000 shares outstanding. Ignore taxes for this problem.

Suppose the company has a market-to-book ratio of 1.0.

Calculate return on equity, ROE, under each of the three economic scenarios before any debt is issued. Also, calculate the percentage changes in ROE for economic expansion and recession, assuming no taxes.

Repeat part (a) assuming the firm goes through with the proposed recapitalization.

Repeat parts (a) and (b) of this problem assuming the firm has a tax rate of 30 percent.

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