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Question 5: (15 marks) Wearne Brothers currently has assets of $100 million and is 100%...

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Finance

Question 5: (15 marks)

Wearne Brothers currently has assets of $100 million and is 100% equity financed. Thec ompany expects a net income of $10 million and it pays out 40% of its net income as dividends. Both net income and dividend are expected to grow at a constant rate of 5% per year. There are 20,000,000 shares outstanding and it is estimated that the current cost of capital is 13.50%.

The company is considering a recapitalization where it will issue $10 million in debt and use

the proceeds to repurchase stock. Investment Bankers have estimated that if the company goes

through with the exercise, its before-tax cost of debt will be 11% and the cost of equity will rise

to 14.50%. The company is in the 40% tax bracket.

a) What is the current share price of the stock (before the recapitalization)? (5 marks)

b) Assuming the company maintains the same payout ratio, what will be the stock price

following the recapitalization? [Assume the market is in equilibrium] (8 marks)

c) Should Wearne proceed with the recapitalization? Why? (2 marks)

[Total: 15 marks]

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