Question

2. AMC Corporation currently expects to generate $40 million free cash flows each year forever, and it currently has $100 million cash. Its cost of capital is 10%. The firm has 10 million shares outstanding and no debt. Suppose AMC uses its excess cash to repurchase shares. After the share repurchase, news will come out that will change AMC’s free cash flow each year will be either $60 million or $20 million.

a.What is AMC’s share price prior to the share repurchase?

b.What is AMC’s share price after the repurchase if its firm value goes up? What is AMC’s share price after the repurchase if its firm value declines?

c. Suppose AMC waits until after the news comes out to do the share repurchase. What is AMC’s share price after the repurchase if its firm value goes up? What is AMC’s share price after the repurchase if its firm value declines?

d. Suppose AMC management expects good news to come out. Based on your answers to parts b and c, if management desires to maximize AMC’s long term share price, will they undertake the repurchase before or after the news comes out? When would management undertake the repurchase if they expect bad news to come out?

e. Given your answer to part d, what effect would you expect an announcement of a share repurchase to have on the stock price? Why?

Answer 1

a). Firm value = FCF/discount rate = 40 million/10% = $400 million

Equity value = firm value - debt + cash = 400 - 0 + 100 = $500 million

Price per share = Equity value/number of shares = 500/10 = $50 per share

b). If AMC uses its cash of $100 million to repurchase stock then at $50 per share, it can repurchase

100/50 = 2 million shares

Number of shares after the repurchase = 10 - 2 = 8 million

Firm value = equity value = 400 million

Share price = 400/8 = 50 per share (share price remains same after the repurchase)

Now supposing the FCFs change to $60 million per year: Firm value = 60/10% = 600 million (since cash of $100 million has already been spent on the share repurchase, the new equity value will be 600 million)

Share price = 600/8 = $75 per share

If FCFs change to $20 million per year: Firm value = 20/10% = 200 million

Share price = 200/8 = $25 per share

c). If the news comes before the share repurchase has happened, then firm value will be expected to be 600 million

Equity value = firm value + cash = 600 + 100 = 700 million

Price per share will be 700/10 = $70 per share

After the repurchase happens, price will remain at $70 per share

If firm value is expected to be 200 million before the repurchase then

Equity value = firm value + cash = 200 + 100 = 300 million

Price per share will be 300/10 = $30 per share

After the repurchase also, the price will remain at $30 per share

d). If AMC management expect the FCFs to increase to $60 million p.a. then it will be better to do the share repurchase before the news comes out as share price will be higher at $75 per share (calculated in part b).

If they expect the FCFs to decrease to $20 million p.a. then it would be better to do the share repurchase after the news comes out as the share price will be comparatively higher at $30 per share (calculated in part c).

e). Based on part (d), it is expected that AMC would prefer to do a share repurchase before good news has come out or after bad news has come out. So, if a share repurchase is announced, as investors would expect good news to come afterwards, the share price would increase.