Question

If a company add debt to is financials to repurchase shares how it affect the company price per share?

I know we should add (debt*tax rate/ shares outstanding) to the initial price but what is the thinking/rationale for using that formula? In other words, if tax shield is interest rate*debt*tax rate why to calculate the new price per share when issuing 15% debt we add back only (debt*tax rate/ shares outstanding)?

Answer 1

The repurchase of the shares through infusing Debt in the capital structure of the company will provide two benefits to the remaining shareholders:

1) The after tax cost of debt is always less than the return on capital after tax, so it will raise the income and wealth of the current shareholders increases. This is satisfied through the formula (debt*tax rate/shares outstanding).

2) The denominator to calculate the EPS got reduced after the repurchase of share through debt infusion, the earning to per share would increase. The higher the repurchase, the more will be EPS.

The impact on the share price of company is that as the EPS grows, the share price will also goes up. This is due to intrinsic value of the share increased with the reduction in the outstanding shares at a point of time.

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