Question

1. CMA Ltd currently has an enterprise value​ (that is, present value of future free cash flows) of $400 million and $100 million in excess cash. The firm has 10 million shares outstanding and no debt. Suppose CMA uses its excess cash to repurchase shares. In the near future there news is scheduled to come out that will change​ AMC's enterprise value to either $600 million or $200 million.

1. Suppose CMA management expects good news to come out. If management’s goal is to maximize price per share, what would be optimal for CMA to do – purchase shares before the news or after the news? Explain, provide necessary computations

2. Now answer question a) assuming that CMA management expects bad news to come out.

3. Suppose CMA announces stock repurchase program before the news release date. What would you expect the announcement to have on the stock price? Why?

Answer 1

a)

In case of GOOD NEWS

Case 1

If the company repurchase the shares before the news

Cash = $100 million, price per share = $50

So, we can repurchase = $100 million / $50 = 2 million shares can be repurchases

Remaining shares = 8 million

Now, if the enterprise value goes

up to $600 million and without any cash left, this is also the value of the equity)

price per share = $600 million/ 8 million shares = $75 per share

Case 2

If the company waits until after the news to make the share repurchase,

If enterprise value goes up i.e., in case of good news = $600 million + $100 million (because you still add the value of the cash reserves) = $700 million

Price per share = $700 million / 10 million = $70

Therefore, from case 1 and 2,

In the case of good news, given that $75 > $70, the company will make the share repurchase before the news arrive, trying to repurchase undervalued shares.

b)

In case of BAD NEWS

Case 1

If the company repurchase the shares before the news

Cash = $100 million, price per share = $50

So, we can repurchase = $100 million / $50 = 2 million shares can be repurchases

Remaining shares = 8 million

Now, if the enterprise value goes down to $200 million and without any cash left, this is also the value of the equity),

price per share = $200 million/ 8 million shares = $25 per share

Case 2

If the company waits until after the news to make the share repurchase,

If enterprise value goes down, i.e., in case of bad news = $200 million + $100 million (because you still add the value of the cash reserves) = $300 million

Price per share = $300 million / 10 million = $30

Therefore, from case 1 and 2

In the case of Bad news, given that $25 < $30, the company will wait until the news arrives and only after will repurchase the shares.

c)

If the management announces a share repurchase before the new release, investors should anticipate good news and the price will increase to $75, after the news release.