Question

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 Dernham Burnham Inc.:

Dernham Burnham Inc. expects to earn $4,200,000 this year. It currently has 830,000 shares outstanding. Each share has a market price of $20 per share. Assuming that the company's price-to-earnings (P/E) ratio remains constant and that its earnings are unaffected by the repurchase, what will be the company’s expected market price per share if it repurchases 70,000 shares at the current market price?

$19.66 per share

$20.75 per share

$21.84 per share

$27.30 per share

Which of these factors are considered an advantage of a stock repurchase? Check all that apply.

The firm might pay too high a price for the repurchased stock.

Repurchases can be used to produce large-scale changes in capital structure.

A repurchase can remove a large block of stock that is overhanging the market and keeping the price per share down.

Answer 1

1) Existing earnings per share = Earnings / Existing no. of shares = $4,200,000 / 830,000 shares = $5.060241

PE Ratio = Market price per share / Earnings per share = $20 / $5.060241 = 3.952381

New no. of shares = 830,000 - 70,000 = 760,000

Total earnings will be the same but earnings per share will change.

New earnings per share = $4,200,000 / 760,000 = $5.526316

New market price per share = New earnings per share x PE ratio = $5.526316 x 3.952381 = $21.84

2) The following two options are advantages of a stock repurchase -

Repurchases can be used to produce large-scale changes in capital structure.

A repurchase can remove a large block of stock that is overhanging the market and keeping the price per share down.