Can anybody explain Example 12 on share repurchase programme. It went out of my head. I am in hurry.
Thanks
Debt is valued at 30m whereas Equity has value 70m. Company plans to repurchase 7m which is 10% of 70m. Company has 2 options either to use the excess cash to buy back shares or use debt financing. Current Debt to Asset ratio = 30% (30 / 100)
- If it uses cash
The new equity would be 63m = 70m existing - 7m repurchased (Treasury Stock Method)
Debt remains the same 30m
Total Assets = 30 + 63 = 93m
So new Debt to Asset Ratio = 30 / 93 = 32% approx (32.25%)
- If it issues more debt to repurchase stock
New Equity would again be 63m
Debt would increase from 30m to 37m
Total Assets = 37 + 63 = 100
New Debt to Asset Ratio = 37/100 = 37%
The Repurcahse of share has effectively increased the leverage as the debt has relatively increased.
It can also be understood in a way that share repurchase decrease equity value and through balance sheet equation where Assets = Liability + Equity, either the decrease in equity is covered by incurring additional liability (debt) or through decreasing assets. The debt weight as percentage to assets increases in either way thus increasing leverage.