Merah Berhad has made the following forecast for the upcoming year based on the companys current capitalization:
| Interest expense | RM2,000,000 |
| Operating income (EBIT) | RM20,000,000 |
| Earnings per share | RM3.60 |
The company has RM20,000,000 worth of debt outstanding and all of its debt yields 10 %. The companys tax rate is 30%. The companys price-earnings (P/E) ratio has traditionally been 10. The companys investment bankers have suggested that the company recapitalize. Their suggestion is to issue enough new bonds at a yield of 10% to repurchase 1,400,000 shares of common stock.
Assume that the repurchase will have no effect on the companys operating income; however, the repurchase will increase the companys dollar interest expense. Also, assume that as a result of the increased financial risk, the companys price-earnings (P/E) ratio will be 10.5x after the repurchase.
Required:
a) What is the net income before the change?
b) How many shares are currently outstanding?
c) What is the current stock price?
d) What would be the expected year-end stock price if the company proceeded with the recapitalization? Should Merah Berhad proceed with the recapitalization?
