In Practice Equity Repurchase and the Dilution Illusion

Some equity repurchases are motivated by the desire to reduce the number of shares outstanding and therefore increase the earnings per share. If we assume that the firm's price earnings ratio will remain unchanged, reducing the number of shares will usually lead to a higher price. This provides a simple rationale for many companies embarking on equity repurchases.

There is a problem with this reasoning, however. Although the reduction in the number of shares might increase earnings per share, the increase is usually caused by higher debt ratios and not by the stock buyback per se. In other words, a special dividend of the same amount would have resulted in the same returns to stockholders. Furthermore, the increase in debt ratios should increase the riskiness of the stock and lower the price earnings ratio. Whether a stock buyback will increase or decrease the price per share will depend on whether the firm is moving to its optimal debt ratio by repurchasing stock, in which case the price will increase, or moving away from it, in which case the price will drop.

To illustrate, assume that an all-equity financed firm in the specialty retailing business, with 100 shares outstanding, has $100 in earnings after taxes and a market value of $1,500. Assume that this firm borrows $300 and uses the proceeds to buy back 20 shares. As long as the after-tax interest expense on the borrowing is less than $ 20, this firm will report higher earnings per share after the repurchase. If the firm's tax rate is 50%, for instance, the effect on earnings per share is summarized in the table below for two scenarios: one where the interest expense is $ 30 and one where the interest expense is $ 55.

Effect of Stock Repurchase on Earnings per Share
Organizing Your Debt

Organizing Your Debt

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