I’m trying to see why this is so. I knowthat when the earnings yield (EPS/price) less than after-tax cost of debt, EPS goes down, but, we know this: Assume EPS = $3/share, with $3M net income and 1M shares outstanding, $3M/1M, and stock price=$40/share. If company repurchases 25k shares, at $40/share, we will have 900k shares outstanding. If we assume NI is what it is unchanged, then EPS should go up. Are we assuming that we adjust NI? I might be seeing the answer…but Consider these two cases, how does EPS change? 1) Repurchase paid for with cash. 2) Repurchase paid for by borrowing $1M at 8%.
If the company repurchases 25k shares, how will you have 900k shares outstanding? (1M - 25k = 975k)
Sorry, make that 975k shares outstanding.
25k share at $40 = 1m we have outstanding shares 1m - 25k = 975k. Earnings prior to repurchase = $3 share Earnings post repurchase with cash = 2mil/975k = 2.05 Earnings post repurchase with borrowing = 3m - (800k) + .4(800k) / 975k = 2520/975k = 2.58. After tax cost of debt = 5.6%, Earnings Yield = 3/40 = 7.5%
I think Net Income is only adjusted in the case of a repurchase using debt (borrowing) because of the interest expense. So the calculation for the second one is pretty straight forward. (3M - (1M*0.08))/975K = New EPS. As for the repurchase with cash, i don’t think net income is affected. Why would it be? Through what?
Here is my slightly related question… CFAI Vol III: Reading 30 - Question 19 , Page 179 With regard to accounting for share repurchases. It seems as though although the initial book value of equity is valued at par, after the share repurchase, the book value of equity is reduced by the market value of the shares repurchased. Is the book value of equity their referring to actually an accumulation of two accounts, one valued at par and another valued at market value. Confusing i know… This will maybe explain what i’m asking better: Inital Book Value of Equity = 750 million (valued at par - 30/share ) Value of share repurchase = $70 million # of shares repurchased = 2 million (at $35/share market value) I get that the total book value of equity has to fall by $70 million. My question is, does this represent a reduction of $60million to the common equity account, and a reduction of $10 million to some other account?? If so, what account? Not sure if this makes any sense (or even matters), its been a long day…
right NI stays the same under repruchase with cash. so its 3/.975 = 3.0769 so repurchase with cash always results an increase in EPS?
I don’t know for sure, man. I mean, Schweser says nothing about it. I haven’t checked the CFAI text. Logic would suggest EPS should increase? But I’m not sure.
Assuming tax rate of 40%: 1) Paid with cash: New EPS=3MM/975K=3.077 2) Paid with Debt: New EPS={3MM-(1MM*[8%(1-.4)])}/975K=(3MM-48K)/975K=3.0277
Dude, why are you adding back the after-tax interest?
Im not I am subtracting it.