Slurp Cola Inc.is all equity financed and generates perpetual annual EBIT of $600.Assume that the EBIT,and all other cash flows,occur at year end and that we are currently at the beginning of a year.Assume that Slurp has a 100% payout rate,1,000 shares outstanding,and that shareholders require a return of 6%.Assume that the tax rate is 0%.
Slurp Cola Inc.is considering an open market stock repurchase.It plans to buy 20% of its outstanding shares at the price of $10.00 per share.The repurchased shares will be cancelled.It will finance the repurchase by issuing perpetual bonds with a coupon rate (and yield)of 4%.Assume that the tax rate is 0%.
If Slurp goes ahead with the repurchase,then what is the stock price after the repurchase is complete?

Question

Quizplus · Accepted Answer

The stock price is equal to the value of levered equity, E_L, divided by the number of shares outstanding after the repurchase. P = 11ea7fdb_fc61_45ed_a768_a717b34ebe5e_TB2902_11 First, determine E_L Since V_L = E_L + D E_L = V_L - D According to M&M Proposition I, the value of the levered firm is equal to the unlevered firm. V_U = V_L Since the value of the unlevered firm is: V_U = 11ea7fdb_fc61_6cfe_a768_9f29b71b406d_TB2902_11 = 11ea7fdb_fc61_6cff_a768_d7cb6e9ce6de_TB2902_11 = $10,000 V_L = $10,000 The value of the debt is equal to the price paid for repurchased shares times the number of shares repurchased: D = P_R × N_R D = $10.00 × (0.20 × 1,000) = $2,000 Therefore, E_L = $10,000 - $2,000 = $8,000 The number of shares outstanding after the repurchase is: N_A = 1,000 - (0.2 × 1,000) = 800 The price per share is the value of equity divided by the shares outstanding: Price = 11ea7fdb_fc61_6d00_a768_d384f7bb4bd3_TB2902_11 = 11ea7fdb_fc61_6d01_a768_7f8691fab9ce_TB2902_11 = $10.00