Guys, question on exercise 7 from Schweser on the Dividends and Shares Repurchases chapter.
They lay out some info on a company considering to declare $20 mn in diviends or repurchase 420 million of common stock in the open market.
They say profits amounted to $56 mn, shares outstanding were 40 mn, current stock price is $28.0 and 52-week range is $20.0 to $36.0. Finally, BV of equity is $880 million and after-tax cost of borrowing is 5.5%. What is the impact on P/E?
According to my understanding, the earnings yield here would be EPS / price, so EPS is $56 mn / 40 mn shares = 1.4 and therefore earnings yield would be 1.4 / 28 = 5%. This is lower than the after-tax cost of borrowing, so EPS should go down post share buyback and P/E would go up, right?
The answer says the opposite. That EPS will increase, and P/E will go down. Anyone?
Note that any option consider debt as a way of funding. You got the after-tax cost of borrowing as an extra info that is not being used in this case. The text says “Distribute money dividends (from the cash of the company), or use that money to repurchase stocks.”
In case debt is involved, it would be as you said above.
Well, actually cash dividends can be distirbuted with the companys own cash or by raising debt. They never said it would be paid by using the companys own cash.
So, when its not clear, we just assume its being paid with cash instead of debt?
Well, the question suggests that the company has $20M in cash to return to owners. And it presents two options: Dividend, or Share repurchase. It doesn’t really say anything about borrowing cash to give money to owners. I think that is reading too much into it.