SS11 question!

[cutiegal]

Hi,

could someone explain the problem? I got lost.

Jayco, Inc. is an all-equity company with 100,000 shares outstanding priced at $50 per share (ks=12%). Jayco pays out all of its after-tax earnings in dividends, and earnings before interest and taxes (EBIT) is $1 million. Jayco's tax rate is 40%. Assume Jayco borrows $1,000,000 at 10% and buys back its own stock at the current market price of $50 per share. As a result, Jayco's ks increases to 13% to reflect the new level of risk to the stockholders. Assume no growth. the stock price is now:

a) $47.43
b) $50.00
c) $51.92
d) $53.33

Could someone please explain this problem to me? I know that I have to calculate the Earnings after-tax (EAT) and EPS, but I am somehow lost on this problem.

Thank you!
Cutiegal

 

[MikeMilken]

The Answer is C.

For this question use the DDM .

P= D1/ke-g

*Assuming Jayco used the 1,000,000 it borrowed to buy back its shares @ 50, then number of shares outstanding is 80,000.

*EBIT =1,000,000, I=100,000, T=360,000 therefore E =540,000, meaning EPS (Dividend paid per share) = 540,000/80,000.

*g=0, since RR=0 (Pays put all earnings)

finally going back to the main formula...

6.75/(.13-0)=51.92


Hope this is right...

 

[cutiegal]

Ohhh...now I get it..........I think I got lost at the part where the company buys back the shares, using the $1 million they borrowed.......

Thank you so much Mike!

Cutiegal