# which one is correct?

GLOBAL DEVELOPMENT CO EXPECTS TO EARN \$6 MILLION NEXT YR. FORTY PERCENT OF THIS AMOUNT , OR 2.4 MILLION HAS BEEN ALLOCATED FOR DISTRIBUTION TO COMMON SHARE HOLDERS. THERE ARE 2.4 MILLION SHARES OUTSTANDING AND THE MARKET PRICE IS 30 A SHARE. GLOBAL BELIEVES IT CAN EITHER USE THE 2.4 MILLION TO REPURCHASE SHARES AT THE CURENT PRICE OF 30PER SHARE OR ELSE PAY A CASH DIVIDEND OF \$1 PER SHARE. IF GLOBAL CHOOSES THE SHARE REPURCHASE OPTION, THE MARKET PRICE OF THE REMAINING SHARES IS CLOSEST TO; A) 12.40 B) 29.00 C) 31.00 D) 30.00 I have seen this question twice in q-bank. And there are 2 different answers I am to figure out the proper one… First answer: 2.4 mill shares x 30 per = 72 mil total market cap. 2.4mil / 30 = 80,000 share repurchase. 2.4-80,000 = 2320000 shares remaining 72mil – 2.4 / 2320000 = 30 thus answer is d… Second answer. Eps= 6 mil/2.4 = 2.50 P/e = 30/2.5 = 12x Share repurchase = 2.4/30 = 80,000 Shares remaining = 2,320,000 New eps = 6mil / 2320000 = 2.586 Share price = new eps x p/e = 2.586 x 12 = 31.03 thus answer is c… first of all what is correct? D or C? the only reason I think it is C is because the question states that the co expects to earn 6 mil next yr. This it is not like the co has this cash on hand or else the answer would be d. but I thought that paying a cash dividend and a share repo have the same effect on shareholder wealth- ignoring taxes… so I am confused as to which the correct answer should be… Anyone have an opinion

I go for answer D. The calculation to derive answer C is not correct. You have to adjust the PE ratio after share repurchase as well. (Share price = New EPS x new PE = 2.586 x 11.6 = 29.99)

this is exactly why i love schweser and hate it at the same time…

Sondin I think you’re missing the point to this question. They are trying to show that you can sometimes save time but just understanding conceptually what is going on. P/E is a valuation measurement and no matter how many shares are outstanding, the multiple itself shouldn’t change unless there has been a fundamental change in the outlook for the company. With a share buyback, the components of P/E (price/sh and earnings/sh) will change but over all the P/E should remain the same - in this case 12x. Perhaps they should have clarified that in the question. But the point to this question I believe is that there not any calculations required. We know what the earnings will be and that there will be less shares to spread them over. Thus, assuming the P/E is a constant 12, the answer must be greater than the current \$30. The only answer that satisfies this is C. On the exam, you are bound to get a couple of these situations where, given the data, conceptually you know what the answer should be. If you scan the answers first, sometimes you can save yourself some time on the exam when you realize there are no calculations required. Hope this helps and good luck to all.

I don’t have the CFAI text so I can’t comment on the illustrations used there. Of course P/E will change with a change in the shares outstanding. My point was no matter what the shares outstanding are, the price will adjust accordingly (theoretically) to keep the the p/e ratio constant because the fundamental value of the company hasn’t changed at all. If a stock was trading at a 12 p/e before the stock buyback, it should trade at 12 after the buyback. All I was saying is I thought the question assumed that, and if so, C is the only answer. When I took Level I years ago, we were hit with a bunch of these questions in the Qbank and part of the excercise was to realize that sometimes you don’t need to do calculations to get the answer. And in fact there a couple of exam questions where this turned out to be the case. Best get a clarification from Schweser as to what they were assuming in the question and what they weren’t. If they were not assuming a constant 12 p/e, then you would be correct. Like I said when I took Level 1, this was assumed. Good luck.

Never assume anything, especially on a level 1 exam. Answer it the most straight forward way possible. I agree with D. Instead of trying to guess what the question is assuming regarding the P/E why not just answer it the first way. It is the most straight forward and requires the least amount of calculations. It may not be the best for your learning and understanding of the material, but it will get you through the test. This is the difference between good test takers and not so good test takers.

i had this question come up twice in q-bank and the first time the answer was \$30 and the second time the answer was \$31. so thats why i am confused. i think the answer should be \$30… seems like most agree w/ me…

The reason the answer was \$31 the second time is because they corrected it from the incorrect original answer. Nikko0355 is correct in realizing the question said “EXPECTS TO EARN \$6 MILLION NEXT YR”. Without knowing what this years earnings are (and we don’t), one should immediately realize then that the 12 p/e is a forward p/e ratio. (You’ll see more of this at Level 2). Thus one is left with the distinct impression this is the p/e to be used. Using this approach, the answer is C. My gut tells me this is an old Qbank question that in my day at Level 1 should be answered consistent with answer C. The CFAI texts may have changed and they are now doing it in way consistent with answer D and Schweser hasn’t updated their approach or reworded the question to be consisitent with the current text. Email Schweser, ask them to clarify the question. You seem to know how to answer it both ways - that’s a good thing. But what is important is to know how CFAI wants it answered. That’s why you should email Schweser. Their approach to the question should be consistent with how it is presented in the CFAI text. And if nikko0355 says they do it in a way consistent with answer D then that is the approach to use. Good luck.

I agree with cfa321. This is an odd question. I am completely sure that if Global is right and they can repurchase shares at 30 the outstanding stock will be worth 30 or less. That kinda means the answer can’t be 31. Good calculation though,

I always thought that the management would buyback the shares if they thought that the value of the stock price was undervalue, so a bulk-block-trade puts the upward pressure on the price of the stock and due to the herding-behavior of the market and the value of the stock rises. So If I would have got this question, I would have just knocked off A, B and D leaving me with only ‘C’ Am I wrong? M I over-analyzing a rather-simple question? … dunno, but it’s just 58-days-left that’s causing the panic in me. - Dinesh S

From L1 material definitely states that Cash Div. and Stock Repurchase mean exactly the same value at the end. 30.00 would be my answer.

dinesh.sundrani Wrote: ------------------------------------------------------- > I always thought that the management would buyback > the shares if they thought that the value of the > stock price was undervalue, so a bulk-block-trade > puts the upward pressure on the price of the stock > and due to the herding-behavior of the market and > the value of the stock rises. So If I would have > got this question, I would have just knocked off > A, B and D leaving me with only ‘C’ > > Am I wrong? M I over-analyzing a rather-simple > question? … dunno, but it’s just 58-days-left > that’s causing the panic in me. > > - Dinesh S There have been lots of academic studies on buybacks. They probably do increase the stock price, but most people think it’s due to signalling. The point is that they announced they would buyback stock at 30. Companies do make such offers but if the stock trades at 35 nobody would do it and it would drive the stock price down (“Yeah, we know its trading at 35, but we only think it’s worth 30”)

of course it’s C…

well I’m not sure about that . it really depends who thinks that the earnings will be 6 mil dollars A if investors think that there will be 2.4 mil distributed to them - that is 1\$ per share that means that the price of 30\$ includes the cash dividend. the price without it would be 29. since cash div and stock repurchase must have same end result it means that the price in the market should be (2.4/2.32)*29=30 B. if company thinks that and investors not that means that the price of 30\$ doesn’t include the dividend and purchasing the stock would lead to a new price of 31\$ .but then again the price should go up not by 2.4 mil but by 6 mil dollars divided amongst the shares I’ll go with A althought i’m not sure this is what they meant

Oh no: I ment D… It’s pretty late…

I ment D too A is stupid