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Expected stock price after recapitalization

Etchabarren Electronics has made the following forecast for the upcoming year based on the company's current capitalization:

Interest expense $2,000,000
Operating income (EBIT) $20,000,000
Earnings per share $3.60

The company has $20 million worth of debt outstanding and all of its debt yields 10 percent. The company's tax rate is 40 percent. The company's price earnings ratio has traditionally equaled 12, so the company forecasts that under the current capitalization its stock price will be $43.20 at year end.

The company's investment bankers have suggested that the company do a recapitalization. Their suggestion is to issue enough new bonds at a yield of 10 percent to repurchase 1 million shares of common stock. Assume that the stock can be repurchased at today's $40 stock price.

Assume that the repurchase will have no effect on the company's operating income; however, the repurchase will increase the company's dollar interest expense. Also, assume that as a result of the increased financial risk the company's price earnings ratio will be 11.5 after the repurchase. Given these assumptions, what would be the expected year-end stock price if the company proceeded with the recapitalization?

a. $48.30
b. $42.56
c. $44.76
d. $40.34
e. $46.90

Solution Preview

Etchabarren Electronics has made the following forecast for the upcoming year based on the company's current capitalization:

Interest expense $2,000,000
Operating income (EBIT) $20,000,000
Earnings per share $3.60

The company has $20 million worth of debt outstanding and all of its debt yields 10 percent.  The company's tax rate is 40 percent.  The company's price earnings ratio has traditionally equaled 12, so the company forecasts that under the current capitalization its stock price will be $43.20 at year end.

The company's investment bankers have suggested that the company do a recapitalization.  Their suggestion is to issue enough new bonds ...

Solution Summary

The solution calculates expected stock price after recapitalization.

$2.19