Expected Price of Company's Stock Following Recapitalization

Expected Price of Company's Stock Following Recapitalization

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Question

The following information applies to Lott Enterprises:

Operating Income (EBIT) $300,000

Debt $100,000 -

Interest Expense $10,000 -

Tax Rate 40%

Shares Outstanding 120,000 -

EPS $1.45 -

Stock Price $17.40 -

The company is considering a recapitalization where it would issue $348,000 worth of new debt and use the proceeds to buyback $348,000 worth of common stock. The buyback will be undertaken at the pre-recapitalization share price ($17.40). The recapitalization is not expected to have an effect on operating income or the tax rate. After the recapitalization, the company's interest expense will be $50,000. Assume that the recapitalization has no effect on the company's price earnings ratio. What is the expected price of the company's stock following the recapitalization?

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Explanations

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Explanation

We can do this problem by using the P/E before and after the recap. Recall that P/E = Price/EPS.

Before the recap -

After recap -

EBIT$300,000 $300,000 -

Interest-10,000-50,000 -

EBT$290,000 $250,000 -

Tax116,000 100,000 -

NI$174,000 $150,000 -

Shares120,000 100,000*

EPS$174,000/120,000$150,000/100,000

= $1.45= $1.50

P/E$17.40/1.45 = 12x -

*120,000 - ($348,000/$17.40)

As P/E = 12 after the recapitalization (recall the question states that it does not change), we know 12 = Price/$1.50 Price = 12 x $1.50 = $18.00.

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