Question

Flychucker Corporation is evaluating an extra dividend versus a share repurchase. In either case $16,000 would be spent. Current earnings are $1.60 per share, and the stock currently sells for $64 per share. There are 5,000 shares outstanding. Ignore taxes and other imperfections. a. Evaluate the two alternatives in terms of the effect on the price per share of the stock and shareholder wealth per share. (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) Alternative I Extra dividend Price per share $ Shareholder wealth $ Alternative II Repurchase Price per share $ Shareholder wealth $ b. What will be the effect on the company’s EPS and PE ratio under the two different scenarios? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) Cash dividend EPS $ PE ratio Share repurchase EPS $ PE ratio

Answer 1

Dividend Payment Option: Total amount to be spent = $16000 ; shares outstanding = 5000; Hence Dividend per share (DPS) = (16000/5000) = $3.2. When the dividend is paid, the stock price will adjust accordingly and the ex-dividend price will be (64-3.2) = $ 60.80. Thus we have:

DPS = $3.2 ; Ex-dividend Price per share = $60.8 ; Shareholder wealth = (60.80 * 5000) + (3.2 * 5000) = 320000 which is same as it was before the dividend pay out. In the absence of taxes and other imperfections, the dividend pay out will not impact the over all shareholder wealth.

Repurchase of shares: Amount to be spent : $16000; At stock price of $64, number of shares that can be repurchased are = (16000/64) = 250. Since the money spent to repurchase is like a transfer from the company to shareholders, the company net assets will decrease by $16000. Company net assets after the repurchase = (64*5000) - 16000 = $304,000. On a per share basis the price should be = 304000/(5000-250) = 64. Hence the stock price should remain unchanged at 64.

Repurchase price : $ 64 and Shareholder wealth : (4750 * 64) + (250 * 64) = $ 320,000 which is same as before the repurchase.

Impact on EPS and P/E ratio :

Dividend alternative : Since the number of shares remain unchanged, the EPS will remain unchanged at $1.6 but the P/E ratio will change to reflect change in price . P/E ratio prior to dividend payment = 64/1.6 = 40 and P/E ratio after the dividend = 60.8/1.6 = 38

Share repurchase alternative : Since the number of shares change, the EPS will also change. Total earnings = 5000 * 1.6 = 8000; after the repurchase the EPS = 8000/4750 = 1.68

The P/E ratio will change from (64/1.6) = 40 to (64/1.68) = 38.10