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.
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.
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.
A. the same as
I. less; increase
A. the same as
The price may change either way or remain constant, depending on how the market responds to such a transaction.
I. The amount of free cash flow available to the company
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.
A. benefit different groups.
I. balance sheet
A stock repurchase is a close substitute for a cash dividend.
A. an increase of $2.78
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.
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.
A. I only
The effect depends on whether the repurchase is financed internally or externally.