Question

1. The Rhino Corporation is considering a recapitalization plan that would increase its debt ratio and increase its interest expense. The company would issue new bonds and use the proceeds to buy back shares of its common stock. The company's CFO thinks the plan will not change total assets or operating income, but that it will increase earnings per share (EPS).
   

1. Do you agree with the CFO that operating income will not change as a result of the recapitalization even though there is an increase in interest expense? Why or why not?   
   
   
2. Under the recapitalization plan, the CFO believes the buy-back of commons stock will increase the earnings per share. Do you agree with this statement? Why or why not?   
   
   
3. What will happen to Rhino Corporation’s intrinsic value if it issues debt and uses the proceeds to buy back share of its common stock? Explain.
   
   

If a company issues more debt to buy back shares of its own common stock, how do market participants perceive it? Explain

Answer 1

1) Operating income of a company means the profit recieved after deducting all operating cost including depreciation and amortisation expenses. The formula is = gross profit from sales- operating expenses= operating income. This is knows as EBIT( earnings before interest and tax), which signifies that operating income is that income wherein interest expenses are not yet deducted. And then there after interest expenses are deducted from it (EBIT)to get income before tax(EBT) , then tax is deducted and we get income after tax or net income.

Thus from the above explanation, it is clear that operating revenue will not get affected as interesr is not deducted at that level but yes, net income at the end will get impacted as by then interest is deducted, which reduces the profit. As per the question, the CFO is right as operating income will remain unaffected by the increase in debt.

2) Yes, i agree to it. It is often believed that buy- back of shares helps to boost shareholder's wealth by increasing EPS. Let us understand with the help of an example.

EPS= total earnings/ outstanding shares of the company.

Say total earnings is 10000$ and shares outstanding is 500 units. At this point EPS = $10000/500 = $20

Say now because of buyback,shares outstanding decreases to 200units and earning remaining the same. Now EPS= $10000/200 =$50.

Hence buy back increases EPS most of the times as outstanding share(denominator) decreases.

3) Intrinsic value of a company means the amout of investment intvestors are willing to do. So intrinsic value is of utmost importance as it is how a companies shares will perfoem in the future. As long as shareholder's goal and motive remain satisfied it will not impact. But if however due to high debt, the company's earnings get reduced, ir will affect shareholder's wealth. Also capitak structure is of utmost relavance in this context therefore debt taken to buyback shares will not affect uoto a certain limit, beyond with it may impact , thus demotivating investors to invest in future.

When a company issues more debt to buy back shares, it means the cash outflow will rise in future due to interest constrains on the company, which at times will affect the company's profitability. Hence investors will not like this as it will lead to lower in demand for the shares of the company as the company wont perfoem better due to huge cash outflow. Thus more of debt to buy back shares is not a welcoming step. Thus there must be a balance of the debt taken for this purpose at they money taken as debt wont increase operational efficiency as being the money used for buyback.