Question

You have an aged relative who is terrified of debt. She runs a company that has zero debt. The company is in steady state. Its annual revenue is fixed at $1,000 and all income is distributed as dividends. There are 40 shares are outstanding. The dividends are $6.00 per share. Its required rate of return (or cost of equity) is 12%. With zero dividend growth this results in a current share price of $50.00. Currently the risk-free rate is 5% and the market risk premium is 7%. So the company’s stock beta is 1.00. This is also the asset beta.

Your aged relative retires and a new CEO is hired. The new CEO sells $1,000 of 7% 100-year bonds and repurchases 20 shares of stock. Nothing else changes in the company. The company’s tax rate is 40%. Construct new financial statements that reflect this change and estimate how much the market price of the stock will change, if at all. There will be no change in revenue and all income will be distributed as dividends.

Pre-Change Income Statement		Post-Change Income Statement
Revenue	$1,000	$1,000
Expenses	600
Taxable Income	400
Taxes	160
Net Income	240
Dividends per share	$6.00
Share Price	$50.00

Pre change Balance Sheet		Post-Change Balance Sheet
Total Assets	$2,000
Debt	0	$1,000
Market Value of Equity	$2,000
Total Liabilities & Equity	$2,000

Answer 1

	Income Statement	Pre-Change	Post-Change
	Revenue	1000	1000
	Expenses	600	670	(600+(1000*7%))
	Taxable Income	400	330
	Taxes	160	132
EPS=6	Net Income	240	198	EPS=198/20=9.9
240/40=6	Dividends per share	6	9.9	198/(40-20)
6/12%=50	Share Price	50	82.47	P/E=8.33
P/E=50/6=8.33				P/E=P/9.9=8.33
	Balance Sheet	Pre-Change	Post-Change
	Total Assets	2000	2649
	Debt	0	1000
50*40	Market Value of Equity	2000	1649	20*82.47
	Total Liabilities & Equity	2000	2649
	So, share price increases to $ 82.47