Assume that Rose Corporation’s (RC) EBIT is not expected to grow in the future a

Question

Assume that Rose Corporation’s (RC) EBIT is not expected to grow in the future and that all earnings are paid out as dividends. RC is currently an all-equity firm. It expects to generate earnings before interest and taxes (EBIT) of $6 million over the next year. Currently, RC has 5 million shares outstanding and its stock is trading for a price of $12 per share. RC is considering borrowing $12 million at a rate of 6% and using the proceeds to repurchase shares at the current price of $12.

Following the borrowing of $12million and subsequent share repurchase, the number of shares that RC will have outstanding is closest to:

(1) 4.0 million
(2) 6.0 million
(3) 4.9 million
(4) 4.5 million

Explanation / Answer

Ans: 4 million Since the stock price is trading at $12 per share and RC will use $12 million to repurchase its stock, it will be able to buy back 1 million shares. This will reduce the outstanding shares to 4 million (5 million - 1 million).

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