Dividends and Share Repurchases Basics  (Reading 39)

Exercise Problems:

1.      The following information is available for a firm:

A plan to repurchase $10 million worth of shares using debt will most likely cause the earnings per share to:

A. increase.

B. decrease.

C. remain unchanged.

Current earnings per share = $6,000,000 ÷4,000,000=$1.50 Earnings yield = $1.50 ÷$20.00=7.5%

The after-tax cost of debt = 10% × [1 – 40%] = 6%, is below the earnings yield, the earnings per share will increase.

Note that a share repurchase using borrowed funds will increase EPS if the after-tax cost of debt used to buy back shares is less than the earnings yield of the shares before the repurchase. It will decrease EPS if the cost of debt is greater than the earnings yield, and it will not change EPS if the two are equal.

2.      A company decides to repurchase 5 million of its outstanding 20 million shares with debt funding. After the repurchase, the company’s after-tax earnings decline by 20%. The new earnings per share (EPS) is most likely:

A. equal to the pre-repurchase EPS.

B. less than the pre-repurchase EPS.

C. greater than the pre-repurchase EPS.

C is correct. EPS =

The outstanding shares decline by 25% (5 million / 20 millions)

Since the after-tax earnings decline (by 20%) less than the outstanding shares do.  The new EPS is greater than pre-repurchase EPS.

3.      A share repurchase method that requires existing shareholders to indicate the number of shares they will tender over a range of prices is most likely an example of a:

A. Dutch auction.

B. repurchase by direct negotiation.

C. purchase of shares on the open market.

A is correct because in a Dutch auction, the company stipulates a range of acceptable prices. Shareholders indicate how many shares they will tender at the various prices.

B is incorrect because when companies negotiate directly with a large shareholder they usually offer a price at a premium to the market price.

C is incorrect because when companies repurchase stock in the open market, the prevailing market price is used.

4.      A firm’s price-to-earnings ratio (P/E) is 12.5. The firm has decided to repurchase shares using external funds that have an after-tax cost of 9%. After the repurchase, the earnings per share will most likely:

A. increase.

B. decrease.

C. remain unchanged.

First convert the P/E to the earnings yield (E/P): 1 ÷ 12.5 = 8%. Because the after-tax cost of the external funds is higher than the earnings yield (i.e., 9% > 8%), the EPS will decrease after the repurchase

5.      Which date in the chronology of a dividend payment is most likely determined by the security exchange? The:

A. declaration date.

B. ex-dividend date.

C. holder-of-record date.

The ex-dividend date is normally determined by the security exchange on which the shares are listed. The corporation determines the holder-of-record date and declaration date.

Notes:

?Declaration date. The date the board of directors approves payment of the dividend.

? Ex-dividend date. The first day a share of stock trades without the dividend. The ex-dividend date is also the cutoff date for receiving the dividend and occurs two business days before the holder-of-record date. If you buy the share on or after the ex-dividend date, you will not receive the dividend.

? Holder-of-record date. The date on which the shareholders of record are designated to receive the dividend.

? Payment date. The date the dividend checks are mailed out or when the payment is electronically transferred to shareholder accounts.

6.      Which of the following share repurchase methods will most likely take the longest to execute?

A. Dutch auction.

B. Fixed price tender offer.

C. Open market repurchases.

Of the methods listed, open market repurchases take the longest time to execute.