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Recapitalization and Value of Operations

1. Michaely Inc. is an all-equity firm with 200,000 shares outstanding. It has $2,000,000 of EBIT, which is expected to remain constant in the future. The company pays out all of its earnings, so earnings per share (EPS) equal dividends per shares (DPS). Its tax rate is 40%.

The company is considering issuing $5,000,000 of 10.0% bonds and using the proceeds to repurchase stock. The risk-free rate is 6.5%, the market risk premium is 5.0%, and the beta is currently 0.90, but the CFO believes beta would rise to 1.10 if the recapitalization occurs.

Calculate the number of shares to be repurchased. Assuming that the shares can be repurchased at the price that existed prior to the recapitalization, what would be the share price following the recapitalization?

2. Vasudevan Inc. forecasts the free cash flows (in millions) shown below. If the weighted average cost of capital is 13% and the free cash flows are expected to continue growing at the same rate after Year 3 as from Year 2 to Year 3, what is the Year 0 value of operations, in millions?

Year: 1 2 3
Free cash flow: -$20 $42 $45

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Solution Preview

See attached Excel file for calculations.

The increase in share price after recapitalization is expected inasmuch as the firm has additional funds without ...

Solution Summary

Using an Excel 97-2003 spreadsheet, this solution addresses two problems. First, it illustrates how to compute the number of shares repurchased in a recapitalization and their expected market values. It then computes the value of operations of a firm, including its terminal value.