Question

6. Stock repurchases 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 St. Sebastian Company: St. Sebastian Company has forecasted a net income of $5,300,000 for this year. Its common stock currently trades at $21 per share, and the company currently has 830,000 shares of common stock outstanding. It has sufficient funds available to pay a cash dividend, but many of its Investors don't like the additional tax liability to which the dividend income subjects them. As a result, St. Sebastian's management is considering making a share repurchase transaction in which it would buy back 80,000 shares of its outstanding shares in the open market by paying the current market share price. Assume that the repurchase transaction will have no effect on either the company's net income or its price-to-earnings (P/E) ratio. What is St. Sebastian's expected stock price after the stock repurchase transaction? (Note: Round your intermediate calculation to two decimal places. Round your answer to two decimal places.) $24.42 per share $23.26 per share $20.93 per share $30.24 per share Which of these factors are considered an advantage of a stock repurchase? Check all that apply Repurchases can be used to produce large-scale changes in capital structure. The price of the firm's stock might benefit more from cash dividends than from a repurchase. Stockholders who sell their stock back to the company might claim that they were not made fully aware of all implications of the repurchase.

Answer 1

Answer 1:

Correct answer is:

$23.26 per share

Explanation:

Before Repurchase:

Earning per share (EPS) = Net Income / Number of shares outstanding = 5300000 / 830000 = $6.39

Price-to-earning (P/E) ratio = Market price / EPS = 21 / 6.39 = 3.29

After Repurchase:

Number of shares outstanding = 830000 - 80000 = 750,000

Given that:

After repurchase P/E ratio and net income remains same.

EPS = 5300000 / 750000 = 7.07

Expected price after repurchase = EPS * P/E ratio = 7.07 * 3.29 = $23.26

Hence option B is correct and other options A, C, and D are incorrect.

Answer (2):

Correct answer is:

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

Explanation:

Companies whose capital structure is heavily weighed with equity, may sell bonds to buyback shares with bond proceeds to increase debt ratio. Stock Repurchase is used to change capital structure to align the same with target capital structure. As such statement A is correct.

Statement B is incorrect as it is not necessary that stock might benefit cash dividends rather than from a repurchase.