Question

The Dillon Company is planning a $1 million share repurchase. Its current stock price is $80 per share, and there are 800,000 shares outstanding prior to the repurchase. Earnings per share without the repurchase would be $4 per share.

1. Assuming the P/E ratio doesn’t change, what would be the share price following the repurchase if the repurchase is funded using excess cash?

a. $80.99

b. $81.27

c. $82.04

d. $82.19

2. Instead of using excess cash, now assume the company funds the repurchase by borrowing at a before-tax rate of 4%. The tax rate is 30%. Assuming the P/E ratio doesn’t change, what would be the share price following the repurchase?

a. $80.16

b. $80.29

c. $80.41

d. $80.56

Answer 1

Answer :-

1. Option b - $ 81.27

2. Option d - $ 80.56

Calculation :-

1. No. Of share repurchased = 1,000,000 / 80

= 12,500

No. Of share after repurchase = 800,000 - 12,500

= 787,500

Total earning = No. Of share * EPS

= 800,000 * 4

= 3,200,000

P/E ratio (old) = 80 / 4

= 20

New EPS = Total earning / No. Of shares after repurchase

= 3,200,000 / 787,500

= 4.063

Given, that P/E ratio will not change (i.e. 20)

So price after repurchase = New EPS * P/E Ratio

= 4.0635 * 20

= 81.27

2. If they use borrowing to repurchase then interest on borrowings will be = 1,000,000 * 2.8% ==> 28,000

After tax borrowing rate = 4% * ( 1- tax rate )

= 4% * ( 1- 0.30 )

= 2.8%

Total earning (now) = 3,200,000 - 28,000

= 3,172,000

New EPS = Total Earning (now) / No. Of shares after repurchase

= 3,172,000 / 787,500

= 4.028

So price after repurchase = New EPS * P/E Ratio

= 4.028 * 20

= 80.56