9. Stock repurchases Aa Aa Companies with excess cash often employ share repurch
ID: 2798096 • Letter: 9
Question
9. Stock repurchases Aa Aa Companies with excess cash often employ share repurchase plans in place of or along with cash dividends. Share repurchase plans can help investors liquidate their holdings by selling their stock to the issuing company and earning from capital gains. Consider the case of Petroxy Inc. Petroxy Manufacturing Inc.expects to earn $5,700,000 this year. The company currently has 870,000 shares outstanding, and the shares have a per-share market price of $21. Assuming that Petroxy's price-to-earnings (P/E) ratio remains constant and its earnings are unaffected by a share repurchase transaction, then the company's expected market price per share-if it repurchases 80,000 shares at the current market price-should be Which of these factors are considered an advantage of a stock repurchase? Check all that apply The price of the firm's stock might benefit more from cash dividends than from a repurchase. Repurchases can be used to produce large-scale changes in capital structure. when a firm distributes cash by repurchasing stock, stockholders have the option to either sell or not sell stockExplanation / Answer
Company repurchases 80000 shares at the current market price of $ 21 per Share.
Total amount of repurchase transaction = 1,680,000.
After repurchase, total outstanding shares = 870,000-80,000 = 790,000 shares.
Current level of Earnings per share before repurchase = Expected Earnings/No of Outstanding shares before repurchase
= 5,700,000/870,000 = $ 6.5517
Current Per Share Price = $ 21.
Current P/E = Market Price/EPS = 21/6.5517 = 3.2053
Now after repurchase Company expects same level of earnings i.e. 5,700,000 with constant P/E ratio. However after repurchase total no of shares are 790,000
Revised EPS after repurchase = 5,700,000/790,000= 7.2152
Assuming P/E ration of 3.2053, Market price after repurchase = EPS * P/E = 7.2152 * 3.2053 = $ 23.1268
1. Assuming No effect on P/E ratio due to share repurchase, company's share price is expected to increase after share repurchase as EPS increases after share repurchase. Accordingly, First factor listed out is not correct.
2. Share repurchase reduces total number of outstanding shares and inturn shareholder's equity. At times, share repurchase is funded by borrowed funds. Thus, it can be used to to produce large scale changes in capital structure. Factor 2 is correct.
3. When company distributes cash by way of Share Purchase, it determines a share price for buy back and investors have option either to sell or not sell stocks owned by them for price fixed by company for buy back. Factor 3 is correct.
But in terms of advantage, factor 1 and 3 may not be termed as advantage of share repurchase. While option 2 could be considered as one of the purpose or advantage of share repurchase.
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