Page 33 - 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. EXAMPLE: Share repurchase with borrowed funds, where the after-tax cost of
• EPS before buyback = $5.00. debt exceeds the earnings yield:Spencer Pharmaceuticals, Inc. (SPI) plans to
• Earnings yield = $5.00 / $50 = 10%. borrow $30 million that it will use to repurchase shares; however, creditors perceive
• After-tax cost of borrowing = 8%. the company to be a significant credit risk, and the after-tax cost of borrowing has
• Planned buyback = 600,000 shares. jumped to 15%. Using the other information from the previous example, calculate the
Calculate the EPS after the buyback. EPS after the buyback.

The conclusion is
that a share
repurchase using
borrowed funds
will increase EPS
if the after-tax cost
of debt used to
buy back shares
is less than the
earnings yield of
the shares before
the repurchase. It
will decrease EPS
if the cost of debt
is greater than the
earnings yield,
and it will not
Because the after-tax cost of borrowing of 15% change EPS if the
exceeds the earnings yield of 10%, the added interest two are equal.
Since the after-tax cost of borrowing of 8% is less than the 10% paid reduces earnings, and the EPS after the buyback
earnings yield (E/P) of the shares, the share repurchase will is less than the original $5.00.
increase the company’s EPS.