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Pipeep Berhad is a manufacturer producing electrical appliances. Currently the company has
no growth opportunities (g = 0), and it pays out all of its earnings as dividends (EPS = DPS).
Pipeeps stock price can be calculated by simply dividing earnings per share by the required
return on equity capital, which currently equals the WACC because the company has no debt.
The company financial information are as follows:
Total assets
RM100 million
Operating income (EBIT)
RM20 million
WACC
10%
Tax rate
30%
No of shares outstanding
2 million
A new appointed CFO beliefs that the company would be much better off if it were to change
its capital structure to 30% debt and 70% equity. After meeting with investment bankers, the
CFO concludes that the company could issue RM30 million of debt at a before-tax cost of 5%.
The RM30 million raised from the debt issue would be used to repurchase stock at the current
price. The repurchase will have no effect on the firms EBIT; however, after the repurchase,
the cost of equity will increase to 11%.
Required:
a) Calculate the stock price before the recapitalization.
(4 Marks)
b) What will be its estimated stock price after the capital structure change if Pipeep Berhad
follows the CFOs advice?
(5 Marks)
c) Should Pipeep Berhad follows the CFO advice?
(1 Marks)
(Total: 10 Marks)
Answer & Explanation
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