Question

. What is the change in share price if a company spends its extra $600,000 to buy back stocks at $31 per share instead of paying $600,000 in cash dividends? The next-period market value of equity is $2,500,000, and 100,000 shares are currently outstanding, with a cost of equity of 15 percent.

Answer 1

Next period market value of the equity = $2,500,000

no. of shares outstanding = 100,000 shares

Market value per share = Next period market value of the equity/ no. of shares outstanding = $2,500,000/ 100,000 = $25

Company wants to spend extra $600,000 to buyback its shares. That means company's total spending will be market value plus extra spending of the company.

Total cost of buyback = $2,500,000 + $600,000 = $3,100,000

Buyback price per share = $3,100,000/ 100,000 = $31

When a company announces buyback the price of that stock will definitely goes up because after buyback the no. of shares outstanding will be reduced and g=hence the shareholders will get more earnings per share than before.

Change in stock price = (buyback price - market price)/ market price

= ($31 - $25)/ $25

Change in stock price = $6/ $25 = 0.24

Change in stock price = 24%

Therefore, there is 24% increase in stock price of the company after it announcing a buyback.