Plastico, a manufacturer of consumer plastic products is evaluating its capital
ID: 2806805 • Letter: P
Question
Plastico, a manufacturer of consumer plastic products is evaluating its capital structure. The book value balance sheet of the company follows: (all numbers in millions) Assets Liabilities Current Assets $1000 Debt $2500 Net Fixed Assets $4000 Equity $2500 Total $5000 $5000 In addition, you are provided the following information • The company’s debt is long-term bonds, the coupon rate is 10%. Bonds are currently rated AA with a Yield to Maturity of 12%. The bond’s market value is 80% of par. • The firm currently has 50 million shares outstanding, the current market price per share is $80. The firm pays a dividend of $4 per share, and has a P/E ratio of 10. • The stock currently has a of 1.2. The T-Bond rate is 8%. • The firm’s tax rate is .40 Plastico is considering a major change in its capital structure. The firm plans to issue $3 billion in new debt and buy back stock. This will cause the firm’s debt rating to drop to CCC. (CCC debt yields 18% in the market). a. Find the cost of equity after this change takes place. b. Find the firm’s WACC. c. Assuming there is no cost of financial distress imposed on the firm, what is the new share price? d. Discuss how financial distress might affect this firm. Include in your discussion the impact on its stock price, and the impact on current bondholders.
Explanation / Answer
C) There would be no impact on share price as there is no cost of financial distress cost given in the question. Thus the share price would remain the same
a) Computation of cost of equity:- P/E ratio = Market price per share/Earnings per share 10 = 80/EPS EPS = 80/10 EPS = $8 Dividend per share = $4 Return on equity = EPS/Market price per share Return on equity = 8/80 Return on equity = 10% Growth rate = ROE*(1-retention ratio) Growth rate = 10%*(1-((8-4)/8)) Growth rate = 5% Current price = Current dividend*(1+g)/(Ke-g) 80 = (4*(1+5%))/(Ke-5%) Ke-5% = (4*(1+5%))/80 Ke-5% = 0.0525 Ke = 0.0525+0.05 Ke = 10.25%