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Assume we live in the Modigliani-Miller world of perfect capital market. Chili Plc is a publicly...

Assume we live in the Modigliani-Miller world of perfect capital market. Chili Plc is a publicly traded, all-equity financed company, and has 1 million shares outstanding. Traditionally, Chili would pay out all its earnings to the shareholders as dividends. The current annual earnings available to shareholders is £10 million (assuming fixed earnings forever) and Chili’s chief financial officer (CFO) is exploring alternative options of payout, and their implications on share price and company value. The first option is that the company will use all £10 million earnings from this financial year to repurchase company shares in the open market instead of paying dividends. The required rate of return for Chili’s shares is 12.5%.

a) Calculate the number of shares outstanding after the share repurchase.

b) Calculate Chili’s share price after the share repurchase.

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Answer #1

Information given:

Shares o/s = 1million

Earnings (constant) = 10 million

dividend payout = 100% of Earnings

g = 0

Reqd rate of return = 12.5%

a. Option of stock repurchase worth 10 million

Value of company = D0/Ke = 10 million/ 12.5% = 80 million

share price = Value of company / shares o/s = 80m / 1m = 80 pounds

No of shares repurchased for 10 million = 10 million / 80 pounds = 125,000

Net shares o/s after repurchase = 10,000,000 - 125,000 = 9,8750,000

b. Share price after repurchase = Value of company/ Net shares o/s after repurchase

= 80 million / 0.9875m shares = 82.02 pounds

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