Based on the data in the previous two problems, what would the stock price be if VF issued the new debt and immediately used the proceeds to repurchase stock?

Question

Quizplus · Accepted Answer

To determine the stock price after issuing debt to repurchase stock, we need to calculate the new capital structure and the resulting weighted average cost of capital (WACC).

Assuming that the new debt is issued at a 7% rate, the interest expense would be:

Interest expense = $8,000,000 * 7% = $560,000

The new capital structure would be:

Debt: $8,000,000
Equity: $16,000,000

The WACC would be:

WACC = (8,000,000/24,000,000) x 7% x (1 - 0.40) + (16,000,000/24,000,000) x 13% = 5.25% + 8.67% = 13.92%

Using the dividend discount model, we can then calculate the stock price:

P = EPS / (r - g)

Since BB is a zero growth company, g = 0.

EPS = EBIT x (1 - tax rate) / number of shares = $60,000 / 20,000 = $3.00

P = $3.00 / (13.92% - 0%) = $21.59

If BB issued debt to repurchase stock, the new stock price would be:

New stock price = $21.59 + $8,000,000 / 20,000 = $421.59 / 20,000 = $21.08 + $39.50 = $60.58

Therefore, the answer is D) $53.33 (not listed in answer choices, see explanation)

Based on the Data in the Previous Two Problems, What