Question

EX4 Sims Corp. will buy back 900 of its 2500 shares outstanding. The return on equity before the buy-back is 14%. The debt-to-equity ratio before the buy-back is 1. Also, the company plans to keep a constant debt level, with an interest rate of 3%. Assume no taxation and perfect capital markets. What will be the new return on equity after the buy-back? [17.09%]

Answer 1

Assume par value per common stock of equity be $1.
Equity before buyback = 2,500 shares * $1 = $2,500

Debt-Equity ratio before buy back = 1

Debt = Equity = $2,500

Weight of debt = Weight of equity = $2,500 / $5,000 = 0.50

WACC = (14%*0.50) + (3%*0.50) = 8.50%

The WACC shall remain same after buyback.

Equity after buyback = (2,500 – 900)*$1 = $1,600

Debt after buyback = $2,500

Debt+Equity = $1,600 + $2,500 = $4,100

Weight of equity = $1,600/$4,100 = 0.3902

Weight of debt = $2,500/$4,100 = 0.61

Weighted cost of debt = 3%*0.61 = 1.83%

Weighted cost of equity = WACC – Weighted cost of debt
= 8.50%-1.83%
= 6.67%

Cost of equity after buyback = Weighted cost of equity/Weight of equity
= 6.67% /0.3902
= 17.09%

New Return on equity after the buy-back = 17.09%.