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### Subject 4. Financial Statement Effects of Repurchases

A share repurchase should be equivalent to the payment of cash dividends of equal amounts in their effect on shareholders' wealth, all things being equal. This means the taxation and information content of cash dividends and share repurchases do not differ.

Examples

Example 1: Equivalent Share Repurchase and Cash Dividends

Company XYZ is expected to have \$10 million in earnings. It plans to distribute \$6 million to shareholders through cash dividends or stock repurchases. The current stock price is \$20. The company has 1 million shares outstanding. The stock repurchase can be completed at \$20.

• Cash dividends

• Per share dividend: \$6 million / 1 million = \$6
• Per share value: \$20 - \$6 = \$14
• Total wealth from ownership of one share: \$14 + \$6 = \$20

• Share repurchase

• Number of shares to be repurchased: \$6 million / \$20 = 0.3 million
• Post-repurchase share price: [1,000,000 x \$20 - \$6,000,000] / (1,000,000 - 300,000) = \$20
• Total wealth from ownership of one share is also \$20.

Example 2: A Share Repurchase that Transfers Wealth

Continuing with the above example, assume that the company has to pay a premium to repurchase shares from a wealthy investor: the stock repurchase price can be completed at \$25 per share.

• Share repurchase

• Number of shares to be repurchased: \$6 million / \$25 = 0.24 million
• Post-repurchase share price: [1,000,000 x \$20 - \$6,000,000] / (1,000,000 - 240,000) = \$18.42
• Shareholders other than the wealthy investor would lose \$20 - \$18.42 = \$1.58 for each share owned. Therefore, the transaction effectively transfers wealth from the other shareholders to this individual investor.

Example 3: Share Repurchases Using Borrowed Funds: The Effect on EPS When the After-Tax Cost of Borrowing Equals E/P

ABC Company wants to borrow \$10 million to repurchase shares.

With the after-tax cost of borrowing equal to the earnings yield (E/P) of the shares, the share repurchase has no effect on the company's EPS. However, if the after-tax cost of borrowing is greater (less) than the earnings yield, EPS will be less (more) than its pre-repurchase level.

A share repurchase may cause the P/E ratio to change as well. For example, if a share repurchase causes a company's financial leverage to change, the financial risk of the company's earnings stream changes and the P/E ratio post-repurchase may change from its pre-repurchase level to reflect the change in risk.

Example 4: The Effect of Share Repurchase on Book Value per Share

Company X and Company Y have announced a \$5 million buyback.

This example shows that book value per share (BVPS) will either increase or decrease depending on whether share price is higher or lower than BVPS. When share price is greater (less) than BVPS, BVPS will decrease (increase) after a share repurchase.

#### Practice Question 1

If, before the buyback, the after-tax cost of borrowing is greater than the earnings yield (E/P) of the shares, the EPS pre-repurchase will be ______ its post-repurchase level.

A. the same as
B. greater than
C. less than

#### Practice Question 2

When BVPS is ______ than share price, BVPS will ______ after a share repurchase, all other factors remaining equal.

I. less; increase
II. greater; increase
III. less; decrease
IV. greater; decrease

#### Practice Question 3

If, before the buyback, the after-tax cost of borrowing is equal to the earnings yield (E/P) of the shares, the P/E ratio pre-repurchase will be ______ its post-repurchase level.

A. the same as
B. greater than
C. less than
D. A, B, and C are all possible outcomes.

The price may change either way or remain constant, depending on how the market responds to such a transaction.

#### Practice Question 4

Two primary sources of financing share repurchases are ______ and ______.

I. debt
II. cash flow from operations
III. issuance of new shares
IV. cash flow from sale of business assets

#### Practice Question 5

A company needs to consider the following factors when contemplating a share repurchase program:

I. The amount of free cash flow available to the company
II. The existing capital structure
III. The dilutive or accretive impact of the repurchases

Correct Answer: I, II and III

The amount of free cash flow available to the company and the existing capital structure (debt to equity levels) are usually the first considerations.

The dilutive or accretive impact of the repurchases must be assessed as well. EPS and cash flow per share are increased to the extent that the number of shares outstanding is reduced, but the earnings may decrease (due to lower interest income or higher interest expense). This impact should be assessed in a pro forma analysis by financial management.

The share purchase decision can also affect the company's other strategies (i.e., investment policy, dividend policy, and capital spending). Therefore, the share repurchase decision must be viewed within the dividend/capital structure/investment decision.

#### Practice Question 6

The most important difference between stock repurchases and cash dividends is that they ______

A. benefit different groups.
B. have different effects on corporate cash flow.
C. have different effects on current stock price.
D. may have different tax consequences.
E. require different accounting practices.

#### Practice Question 7

Share repurchases affect the ______.

I. balance sheet
II. income statement
III. cash flow statement

Correct Answer: I, II and III

#### Practice Question 8

The stock ______ is a close substitute for a cash dividend.

A. dividend
B. split
C. repurchase

A stock repurchase is a close substitute for a cash dividend.

#### Practice Question 9

A firm that is 100 percent stock financed with assets of \$1 million is considering a stock repurchase of 10 percent of its shares. Assume the firm has 20,000 shares outstanding and that net income is \$120,000. Assume that book and market values are identical. The impact of the repurchase on the stock price would be closest to ______.

A. an increase of \$2.78
B. an increase of \$5.56
C. There will be no change.

Currently, the stock price is \$1,000,000/20,000 = \$50/share, the current EPS is \$120,000/20,000 = \$6/share, and the P/E ratio is \$50/\$6 = 8.33x. Assuming that the stock repurchase does not impact the firm's earnings or P/E ratio, then the post-repurchase EPS will be \$120,000/(20,000-2,000) = \$6.67 and the post-repurchase share price will be 8.33 x \$6.67 = \$55.56. This is an increase of \$5.56.

#### Practice Question 10

The current price of Company X's common shares is \$50. Its estimated P/E ratio is 25x. If the company borrows funds to finance a stock repurchase at its after-tax cost of capital of 6%, its EPS will ______.

A. increase
B. decrease
C. decrease first, then increase gradually in future years

Since the earnings yield is 1/25 = 4%, which is lower than the after-tax cost of financing, earnings dilution will result from the buyback.

#### Practice Question 11

A share repurchase may ______ EPS.

I. increase
II. decrease
III. have no effect on

A. I only
B. II only
C. I, II and III

The effect depends on whether the repurchase is financed internally or externally.