some good ideas in here. Because this installation is mostly cosmetic you can get away with a few things you couldn't in a wet environment like a shower.
I would probably just get rid of all the frayed paper, and mud over the area til its smooth, prime and tile.
If you replace the drywall, cut an inch inside the damaged area, use some scrap 2x4 to back the edges and add in a new piece. use mesh and con fill for your joints, it's stronger and you can get away with one pass since it's all going to be under the tile. Just make sure its smooth. You can use some mud on the edges for a finished look as you've got torn paper in the painted area.
You can buy small pieces of drywall at some building stores, costs more per sq ft but you don't have to take a whole sheet home.
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