Question

CASA has no debt. The action's beta, BE, is 1.2 and its expected return, RE, is 12.5%. The company decides to go into debt at the risk-free rate, Rf, of 5% to buy 40% of its shares. Capital markets are assumed to be perfect:
a) Find the value of RE after the buyback operation knowing that before the operation the expected earnings per share (EPS) was $ 1.5 and the expected PER (the ratio between the share price and the Expected EPS) is 14.
b) What is the expected EPS of the company after the operation? Is this change beneficial to shareholders?
c) What is the expected PER after the operation? Does this sound reasonable?

Answer 1

Given, The beta= 1.2 , RE = 12.5%., (Rf)=5%

The company decided to go into debt risk-free (Rf)=5%  and decides to purchase 40% of shares

So Ratio = 60:40 (60% equity and 40% debt)

Calculation of WACC (Rm)= (60/100*12.5% + 40/100* 5%)= (7.5+2)= 9.5%

a) Find the value of RE after the buyback operation

Re= Rf+ Beta(Rm-Rf)  = {5%+1.2(9.5%-5%)} = 10.4%

It is also given that EPS- $1.5 and PER = 14

So PER=( Price/EPS)

= 14=(Price/$1.5)

= Price= $21

b) EPS after operation will automatically increase due to company buying its own shares so it is beneficial to the shareholder as their EPS will increase as compared to EPS Before opeartion that is before buy back.

Given that company repurchased 40% of its share. So present share = 60%

Particular	EPS	Working
Before Buy Back (100% equity)	1.5	Given
After Buy Back(60% equity)	2.50	100/60=(1.67*1.5)=2.50 (Earning is split among fewer shares)

c)Expected PER after operation = (Price/EPS) = ($21/2.50) = 8.4

It can be seen that PER has decreased after operations and lower PER means shares are undervalued so it doesnt sound reasonable.

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