Tangshan Mining Company must choose its optimal capital structure. Cu

Tangshan Mining Company must choose its optimal capital structure.

Currently, the firm has a 40 percent debt ratio and the firm expects to generate a dividend next year of $4.89 per share and dividends are expected to grow at a constant rate of 5 percent for the foreseeable future. Stockholders currently require a 10.89 percent return on their investment. Tangshan Mining is considering changing its capital structure if it would benefit shareholders. The firm estimates that if it increases the debt ratio to 50 percent, it will increase its expected dividend to $5.24 per share. Because of the additional leverage, dividend growth is expected to increase to 6 percent and this growth will be sustained indefinitely. However, because of the added risk, the required return demanded by stockholders will increase to 11.34 percent.
(a) What is the value per share for Tangshan Mining under the current capital structure?
(b) What is the value per share for Tangshan Mining under the proposed capital structure?
(c) Should Tangshan Mining make the capital structure change? Explain.

ANSWER

(a) The current price of Tangshan Mining stock is:
P = $4.89 / (0.1089 – 0.05 ) = $83.02
(b) The price of Tangshan Mining stock if the capital structure change is made is expected to be:
P = $5.24 / (0.1134 – 0.06 ) = $98.13
(c) Yes. Tangshan Mining should make the change because it will maximize share price.