Powell Plastics, Inc. (PP) currently has zero debt. Its earnings before interest and taxes (EBIT) are $80,000, and it is a zero growth company. PP’s current cost of equity is 10%, and its tax rate is 40%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $48.00. Assume that PP is considering changing from its original capital structure to a new capital structure with 35% debt and 65% equity. This results in a weighted average cost of capital equal to 9.4% and a new value of operations of $510,638. Assume PP raises $178,723 in new debt and purchases T-bills to hold until it makes the stock repurchase. PP then sells the T-bills and uses the proceeds to repurchase stock. How many shares remain after the repurchase, and what is the stock price per share immediately after the repurchase?

How many shares remain after the repurchase, and what is the stock price per share immediately after the repurchase?

Explanation:

EBIT $80,000

zero growth rate

Cost of equity (Re) 10%

tax rate 40%

10,000 common stocks outstanding at $48

they want to change from 100% equity to 35% debt and 65% equity

WACC = 9.4%

new value of operations $510,638

PP's value of operations = {$80,000 x (1 - 40%)} / WACC = $510,638

the new stock price should = $510,638 / 10,000 stocks = $51.06

Stock price will be $51.06

approximately $178,723 / $51.06 = 3,500 stocks should be repurchased

9.4% = ($480,000/$658,723 x 10%) + ($178,723/$658,723 x cost of debt x (1 - 40%)

9.4% = 7.29% + ($178,723/$658,723 x cost of debt x (1 - 40%)

2.11% = 0.2713 x cost of debt x 0.6

2.11% = 0.1628 x cost of debt

cost of debt = 2.11%/0.1628 = 12.96%

new WACC = ($178,710/$357,433 x 10%) + ($178,723/$357,433 x 12.96% x 0.6) = 5% + 6.48% = 11.48%

PP's value of operations = {$80,000 x 0.6} / 11.48% = $418,118

the new stock price should = $418,118 / 6,500 stocks = $64.33

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