Background: Your friend owns 1,000 shares of stock of GameStore Inc., a prominent video game retailer, which currently has 1 million shares outstanding. Your friend thus owns .1% of the firm, as currently structured.

17. Next, suppose that the company repurchases 20% of its shares using cash that it already had on hand. It will have 800,000 shares outstanding after doing this, and the firm had to spend $5 million (200,000 shares times $25 per share) to do this. Calculate the new efficient price of the stock (the price that the stock should be if investors had the same information as corporate insiders). To do this, calculate the efficient market capitalization before the repurchase, subtract the $5 million that the firm spent on the repurchase, and divide by the new number of shares outstanding. If the market comes to its senses, so that the stock eventually trades at its efficient price, what return will shareholders get now?

#18 - Are the price/return you calculated in the last part higher or lower than what you calculated two questions ago? Do stock buybacks have an eventual effect on share price when the firm is undervalued by investors? Based on this, if market participants believe that corporate management knows more than investors about the value of the firms projects, would they likely believe that share repurchases are a signal that the firm is overvalued or undervalued? What signal would the market draw from issuance of new shares? 19. We know that in the real world, this firms financing itself with all equity would not be ideal, because of the debt tax shield. Yet, the tax deductibility of debt seems to imply that firm value would always increase by raising more debt and we do not see many firms that come anywhere close to 100% debt financing in practice. Why might this be?