Dabney Electronics currently has no debt. Its operating income is $20 million and its tax rate is 40%. It pays out all of its net income as dividends and has a zero growth rate. The current stock price is $40 per share, and it has 2.5 million shares of stock outstanding. If it moves to a capital structure that has 40% debt and 60% equity (based on market values), its investment bankers believe its weighted average cost of capital would be 10%. What would its stock price be if it changes to the new capital structure?
A) $40
B) $48
C) $52
D) $54
E) $60

Question

Quizplus · Accepted Answer

The firm's value can be calculated using the formula for the value of a no-growth firm: Value = Operating Income * (1 - Tax Rate) / WACC. With the new capital structure, the value is $20 million * (1 - 0.4) / 0.10 = $120 million. With 2.5 million shares, the stock price would be $120 million / 2.5 million = $48 per share.

Dabney Electronics Currently Has No Debt