ADDITIONAL QUESTION 1 Share buybacks are sometimes motivated by the desire to in

Question

ADDITIONAL QUESTION 1 Share buybacks are sometimes motivated by the desire to increase earnings per share. Falcon Ltd recorded an operating profit of $2 million in the last financial year. It has 4 million shares on issue and the market price of the shares is $5 each. Falcon announces that it will repurchase 10 per cent of each shareholder's shares at $5 per share. a) Calculate Falcon's price-earnings ratio before the buyback. b) An observer comments as follows: 'Falcon's buyback should boost its earnings per share from 50 cents to 55 cents, so with the price-earnings ratio remaining the same, the share price should increase i) If the observer's argument is correct, what will Falcon's share price be after the buyback? ii) Critically evaluate the observer's argument. [Tip: A common 'multiple' used in financial markets is the Price: Earnings ratio which measures the ratio of share price to earnings per share. It measures share price per dollar of earnings and is seen by many market participants as a useful measure of the pricing of a stock relative to other comparable stocks. For example -one might multiply the EPS of a company by the average P/E ratio of companies in the same industry to gain an insight into whether the company's shares are mispriced

Explanation / Answer

a) Price-Earnings ratio = price per share / earnings per share

price per share = $5

earnings per share = $2 million / 4 million shares = $0.5 or 50 cents

Price-Earnings ratio = 5 / 0.5 = 10

b) Number of shares bought back = 10% of 4 million = 400,000

Number of shares outstanding = 4 million - 400,000 = 3.6 million

Earnings per share after the buyback = 2 million / 3.6 million = $.55 or 55 cents

i) Observer's argument is that the P/E ratio remains same after the buyback.

P/E ratio before the buyback = 10 = P/E ratio after the buyback

10 = P / 0.55

So, P = 0.55 * 10 = $5.5.

$5.5 will be the Falcon's share price after the buyback, if the observer's argument is correct.

ii) Although the price may increase in the near term owing to the fact that EPS increases immediately after the share buyback, it doesn't increase the value to existing shareholders in the long run. The value of the equity in the long-run is driven by the company's fundamentals - it's free cash flows, risk, and the growth.

And, it's not always the case that the price increases after the share repurchase. Increase in EPS may result in P/E ratio to decrease with little or no increase in price.

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.