Question

Company A has €150m in cash and its other (operating) assets have a €520m book value. It

has 100 million shares trading at €9 and no debt. The cash is in bank accounts and government

bonds yielding in total a very safe annual return of 2%, i.e., cash is forecast to generate

earnings of €3m by yearend. The operating assets are forecast to generate earnings of €52m

by yearend. An activist investor argues that all that cash is depressing the company’s return

on equity (ROE) and its earnings per share (EPS), and advocates a large payout of some form.

Under pressure, management is considering three options: the status quo, a large dividend or

a large buyback.

m. Under the status quo (i.e., without paying out the cash), what is the market value of

the operating (i.e., non-cash) assets? What are the forecast ROE and EPS for the year?

n. Say management opted to use the cash to pay an exceptional €1.5 dividend per share.

(To simplify, say this occurs immediately). What would be the new ROE and EPS

forecasts? What would be the ex dividend stock price and the cum dividend stock

price?

o. Say management opted to use the cash in a self-tender share repurchase. (To simplify,

say this occurs immediately). The company would offer to buy up to 10 million shares

at €15 for a total of €150m (or less). If shareholders tendered (i.e., offered the

company) fewer than 10 million in total, the company would buy them all. If they

tendered more than 10 million shares, they would be rationed on a pro rata basis. For

instance, if shareholders tendered 20 million shares in total, each shareholder who

tendered some shares would in fact sell only half of those shares. Would more/fewer

than 10 million shares be tendered? How many shares would be repurchased? What

would be the stock price post-buyback? What would be the new forecast ROE and

EPS? What would be the pre-repurchase stock price after the announcement of the

repurchase?

p. Which of the three options, if any, achieve the activist’s goal of increasing ROE?

Explain. Which option, if any, achieve the activist’s goal of increasing EPS? Explain.

Which option makes shareholders better off?

Answer 1

m. Under the status quo,

ROE = ((3m+52m)/(520m+150m))*100

= (55m/670m)*100

= 8.2%

EPS = €55m/100m shares

= €0.55/share

n. If management opts for paying out dividend.

ROE = €52m/€520m

= 10%

EPS = €52m/100m shares

= €0.52/share

o. If management opts for buy back shares

All of the shares proposed to buy back will be repurchased since buyback price is €15 which is more then currently trading price of €9.

ROE = €52m/€520m

= 10%

EPS = €52m/90m shares

= €0.58/share

Pre purchase share price will be €

p. Option m and n will achieve acitivist goal to increase ROE since cash which was yielding low return, is being used to pay dividends/buyback shares.

Option n will help activist goal to increase EPS, since that will increase earning per share (due to less shares in circualtion)

Share holders will be better off with option to buyback the shares since it will benifit them in all the aspects.