Page 31 - FINAL CFA II SLIDES JUNE 2019 DAY 6

What if the company borrows READING 22: DIVIDENDS AND SHARE REPURCHASES: ANALYSIS
funds to buy back the stock?

MODULE 22.2: STOCK BUYBACKS

EXAMPLE: Share repurchase when the after-tax cost of debt is less than the earnings yield: Spencer Pharmaceuticals, Inc. (SPI) plans to borrow
$30 million that it will use to repurchase shares. SPI’s chief financial officer has compiled the following information:
• Share price at the time of buyback = $50.
• Shares outstanding before buyback = 20,000,000.
• EPS before buyback = $5.00.
• Earnings yield = $5.00 / $50 = 10%. EXAMPLE: Share repurchase with borrowed funds, where the after-
• After-tax cost of borrowing = 8%. tax cost of debt exceeds the earnings yield:Spencer Pharmaceuticals,
• Planned buyback = 600,000 shares. Inc. (SPI) plans to borrow $30 million that it will use to repurchase shares;
Calculate the EPS after the buyback. however, creditors perceive the company to be a significant credit risk,
and the after-tax cost of borrowing has jumped to 15%. Using the other
information from the previous example, calculate the EPS after the
buyback.

If after-tax cost of borrowing (8%) < 10% earnings yield (10%), share repurchase will increase the company’s EPS; otherwise it will reduce EPS!