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Stock price after recapitalization (repurchase of shares)

Flood Motors is an all-equity firm with 200,000 shares outstanding. The company's EBIT is $2,000,000, and EBIT is expected to remain constant over time. The company pays out all of its earnings each year, so its EPS equals its DPS. The company's tax rate is 40%.

The company is considering issuing $2 million worth of bonds (at par) and using the proceeds for a stock repurchase. If issued, the bonds would have an estimated YTM of 10%. The risk-free rate is 6.6%, and the market risk premium is 6%. The company's beta is currently 0.9, but investment bankers say the beta will rise to 1.1 if the recapitalization occurs.

Assume that the shares are repurchased at a price equal to the stock market price prior to the recapitalization. What would be the company's stock price following the recapitalization?

Solution Preview

Flood Motors is an all-equity firm with 200,000 shares outstanding. The company's EBIT is $2,000,000, and EBIT is expected to remain constant over time. The company pays out all of its earnings each year, so its EPS equals its DPS. The company's tax rate is 40%.

The company is considering issuing $2 million worth of bonds (at par) and using the proceeds for a stock repurchase. If issued, the bonds would have an estimated YTM of 10%. The risk-free rate is 6.6%, and the market risk ...

Solution Summary

The solution calculates the company's stock price following recapitalization (repurchase of shares using the proceeds from a bond issue).

$2.19