Page 28 - FINAL CFA II SLIDES JUNE 2019 DAY 6

LOS 22.i: Calculate and compare the effect of a share repurchase on
earnings per share when 1) the repurchase is financed with the company’s READING 22: DIVIDENDS AND SHARE REPURCHASES: ANALYSIS
surplus cash and 2) the company uses debt to finance the repurchase.
EXAMPLE: Methods of financing a stock repurchase and their effect on EPS: JetFun Inc. MODULE 22.2: STOCK BUYBACKS
has 10 million shares outstanding and has just reported net income of $50 million. Because the
company has $100 million of excess cash currently earning no return, it wishes to repurchase 2
million JetFun shares at a premium of 25% over the current market price of $40.

Calculate and compare the effect of repurchase on EPS when the repurchase is:
(1) financed using the existing surplus cash, or
(2) financed using new debt borrowed at an after-tax interest rate of 3%.

Answer: Current EPS = $50 million / 10 million shares = $5
Repurchase price = $40 + 25% premium = 40(1.25) = $50 per share
Total cost of repurchase = $50 × 2 million shares = $100 million!

Number of shares outstanding after buyback =
10 − 2 = 8 million shares
Using new debt:
Using surplus cash: after-tax cost of funds = 3% of $100 million or $3 million
foregone income = $0 earnings after deducting the cost of funds = 50 – 3 = $47 million
new EPS = $47 million / 8 million shares = $5.875 (an increase of 17.5% from $5)
new EPS = $50 million / 8 million shares = $6.25
(an increase of 25% from $5) Note: Earnings yield before repurchase = EPS / price paid per share = 5/50 = 10%.
When earnings yield is greater than the after-tax cost of debt (as in both funding
scenarios here), EPS will increase due to the repurchase.

However, the firm will then also have higher leverage and, therefore, a higher cost of capital. Accordingly, an increase in EPS
should not automatically lead to an increase in share price or in shareholder wealth.