Derek's Dinghies and Rafts (DDR)is the world's largest manufacturer of rowboats and rafts.At the end of the current year,analysts expect DDR's EBIT to be $2M and they expect the same earnings annually in perpetuity.DDR's shareholders require a return of 12.5% and there are 5M common shares outstanding.DDR has debt with a total face value of $5M.The bonds have an annual coupon of 3%,are rated AAA and yield 3%.The CFO of DDR believes that the company is under-levered.To increase the leverage,the CFO proposes to repurchase 1.2M shares at a price of $1.25 per share.The repurchase will be financed by additional borrowing.The corporate tax rate is 40%.What is the value of the company prior to the repurchase,and what is the stock price after the repurchase?
A) Value (prior) = $9.6M; Stock price (after) = $1.50
B) Value (prior) = $9.6M; Stock price (after) = $1.14
C) Value (prior) = $11.6M; Stock price (after) = $1.50
D) Value (prior) = $11.6M; Stock price (after) = $1.14
E) Value (prior) = $11.6M; Stock price (after) = $3.21

Question

Quizplus · Accepted Answer

This solution uses Modigliani & Miller Proposition I with taxes. V_U = 11ea7fdb_fc65_16bb_a768_7d2cbed2f5ed_TB2902_11 V_U = 11ea7fdb_fc65_16bc_a768_efe8b1d61612_TB2902_11 = $9.6M Prior to the repurchase DDR has $5M of debt outstanding. V_L = $9.6M + 0.40 × $5M = $11.6M After the repurchase, debt will rise by the cost of the repurchase: D = $5M + 1.2M × $1.25 = $6.5M The value of the (levered) firm after the repurchase is: V_L = V_U + T × D V_L = $9.6M + 0.40 × $6.5M = $12.2M The value of levered equity after the repurchase is: E_L = V_L - D E_L = $12.2M - $6.5M = $5.7M The stock price is after the repurchase is: Price = 11ea7fdb_fc65_16bd_a768_4399de7e4ff6_TB2902_11 Solve for the number of shares outstanding, N_A N_A = N_B - N_R N_A = 5M - 1.2M = 3.8M Therefore, the stock price after the repurchase is: Price = 11ea7fdb_fc65_16be_a768_d9bcf0ae631b_TB2902_11 = $1.50

Derek's Dinghies and Rafts (DDR)is the World's Largest Manufacturer of Rowboats