The Carlton Corporation has $5 million in earnings after taxes and 2 million sha

Question

The Carlton Corporation has $5 million in earnings after taxes and 2 million shares outstanding. The stock trades at a P/E of 20. The firm has $4 million in excess cash.

a. Compute the current price of the stock?

b. If the 4 million is used to pay dividends, how much will dividends per share be?

c. If the 4 million is used to repurchase shares in the mrket at a price of 54 per share, how many shares will be acquired?

d. What will the new earnings per share be?

e. If the P/E ratio remains constant, what will the price of the securities be? By how much, in terms of dollars, did the repurchase increase the stock price?

f. Has the stockholders' total wealth changed as a result of the stock repurchase as opposed to receicing the cash dividend?

g. What are some reasons a corporation may wish to repurchase its own shares in the market?

c. If

Explanation / Answer

a) Current Price of Stock = P/E ratio * Earning Per Share = 20 * (5/2) = $ 50

b) Dividend Per Share = 4 million / 2 million = $ 2

c) Shares Repurchase = 4 million / 54 = 74074 shares

d) New EPS = 5 million / ( 2 million - 74074) = 2.60 approx

e) New Price of security = 2.60 * 20 = $ 52 per share.

% increase in stock price after repurchase = ( 52 -50 ) /50 = 4%

f) Stockholders total wealth is measured by the value of assets available with the company. So, either we give a dividend or repurchase stock in the market , both will result in outflow of cash. Hence there will be no change in the total wealth for share repurchase vis a vis dividends

g) Some reasons when a corporation wishes to repurchase shares are:

i) Excess Cash reserves which are lying idle with the company

ii) To drive up the stock market price artificially for a temporary period

iii) To increase the Earning per share and thus show a better relative return on investment

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