Derek’s Dinghies and Rafts (DDR) is the world’s largest manufacturer o

Derek’s Dinghies and Rafts (DDR) is the world’s largest manufacturer of rowboats and rafts. At the end of the current year, analysts expect DDR’s EBIT to be $2M and they expect the same earnings annually in perpetuity.

DDR’s shareholders require a return of 12.5% and there are 5M common shares outstanding. DDR has debt with a total face value of $5M. The bonds have an annual coupon of 3%, are rated AAA and yield 3%. The CFO of DDR believes that the company is under-levered. To increase the leverage, the CFO proposes to repurchase 1.2M shares at a price of $1.25 per share. The repurchase will be financed by additional borrowing. The corporate tax rate is 40%. What is the value of the company prior to the repurchase, and what is the stock price after the repurchase?
A) Value (prior) = $9.6M; Stock price (after) = $1.50
B) Value (prior) = $9.6M; Stock price (after) = $1.14
C) Value (prior) = $11.6M; Stock price (after) = $1.50
D) Value (prior) = $11.6M; Stock price (after) = $1.14
E) Value (prior) = $11.6M; Stock price (after) = $3.21

ANSWER

C