recapitalization tartan industries currently has total capital equal to $4 million, has zero debt, is in the 25% federal-plus-state tax bracket, has a net income of $1 million, and distributes 40% of its earnings as dividends. net income is expected to grow at a constant rate of 3% per year, 200,000 shares of stock are outstanding, and the current wacc is 12.30%.

A stock entitles investors to future residual earnings of a firm through the distribution of dividends. The price of a stock is therefore strongly tied to the expected future stream of dividends. The dividend growth model assumes dividend grows at a constant rate indefinitely and offers a simple expression for the stock price.

Part a.

We can use the dividend growth model to compute the stock price as follows:

stock price = current dividend per share *(1 + dividend growth rate) / (required return - dividend growth rate).

The current dividend per share = 1 million * 40% / 250,000 = 1.6.

Dividend growth rate = growth rate of net income = 3%,

the required return = WACC = 12.30% (because the firm is an all-equity firm). Applying the dividend growth model, the price of the stock = 1.6*(1 + 3%) / (12.30% - 3%) = 16.98

Part b.

Applying the Modigliani-Miller theorem

The value of the levered firm = value of unlevered firm + value of debt * tax rate = 4 million + 2 million * 40% = 4.8 million.

So the value of the equity after recapitalization = 4.8 - 2 = 2.8 million.

The number of shares outstanding = 250,000 - 2 million / 16.98 = 103062

So the value per share = 2.8 million / 175,898 = 27.16

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