3. It has been argued that you can analyze the impact on the stock price of any

Question

3. It has been argued that you can analyze the impact on the stock price of any capital structure or payout decision by looking at two factors.

a. What are these two factors and how do they effect the stock price?

b. In the light of the above answer, analyze the following capital structure changes:

i. A repurchase of equity financed with a new debt issue

ii. A new bond issue

iii. The repurchase of debt financed with a new equity issue.

c. What is wrong with the following statement: "It has been argued that the stock price declines as a result of a new stock issue because of dilution of the existing shares. That is, as you increase the number of shares earnings per share must decline since total earnings is divided by a larger number to get earnings per share."

Explanation / Answer

a) The required return and the growth rate are the factors that affect the growth rate. Apart from the payout ratio and the capital structure, these two influence the stock price.

b) The repurchase of equity with a new bond issue would increase the debt and decrease the equity in the capital structure.

2) A new bond issue would only increase the debt portion of the capital strcuture.

3) The repurchase of debt with equity would increase the equity and decrease the debt in the capital structure.

c) The statement is false because if new shares are issued, the sales will increase and therefore the net income will increase. hence, the EPS does not decrease because the total earnings were increased.

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