Question
5. a) Show that a stock repurchase is conceptually the same as a cash dividend using the following example: Repo Corp. has 1,000 shares outstanding
5. a) Show that a stock repurchase is conceptually the same as a cash dividend using the following example: Repo Corp. has 1,000 shares outstanding at a market price of $20 per share. In debating whether to declare a 5 percent cash dividend, the directors instead chose to repurchase 50 of the outstanding shares.
b) Equity Inc. is currently an all-equity financed firm. It has 10,000 shares outstanding that sell for $20 each. The firm has an operating income of $30,000 and pays no taxes. The firm contemplates a restructuring that would issue $50,000 in 8 percent debt, which will be used to repurchase stock. Show the value of the firm, EPS, and rate of return on the equity before and after the proposed restructuring. What changed?
c) Equity Inc. is currently an all-equity financed firm. It has 10,000 shares outstanding that sell for $20 each. The firm has an operating income of $30,000 and pays no taxes. The firm contemplates a restructuring that would issue $50,000 in 8 percent debt, which will be used to repurchase stock. Assuming that individuals have the same borrowing opportunities as corporations, explain how an investor can sythesize the leverage that is proposed by Equity Inc. Under these conditions, what is the value of restructuring to a firm?
d) Show how leverage increases financial risk by calculating the EPS and return on equity for a firm with $1 million in 10 percent debt. The firm also has 50,000 shares outstanding that sell for $40 each. Three states of the economy are possible: a slump under which the firm would have operating income of $150,000, a normal state under which the firm will earn $420,000, and a boom under which the firm will earn $600,000. The firm pays no taxes.
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