Consider the case of Dernham Burnham Inc.: Dernham Burnham Inc. has forecasted a
ID: 2621286 • Letter: C
Question
Consider the case of Dernham Burnham Inc.:
Dernham Burnham Inc. has forecasted a net income of $5,100,000 for this year. Its common stock currently trades at $22 per share, and the company has 870,000 shares of common stock outstanding. It has funds available to pay a cash dividend, but many of its investors don't like the tax liability that the dividends subject them to.
1.) As a result, the company is considering a stock repurchase in which it would buy back 75,000 shares of its outstanding shares on the open market at the current market price. If the repurchase will have no effect on either the company's net income or its price-to-earnings (P/E) ratio, then what is Dernham Burnham Inc.'s expected share price after the stock repurchase?
A) $24.08 per share
B) $26.49 per share
C) $28.90 per share
D) $30.10 per share
2.) Which of these factors are considered an advantage of a stock repurchase? Check all that apply.
A) The firm might pay too high a price for the repurchased stock.
B) A repurchase can remove a large block of stock that is overhanging the market and keeping the price per share down.
C) When a firm distributes cash by repurchasing stock, stockholders have the option to either sell or not sell stock.
Explanation / Answer
Option a) Correct option
1. Price to earnings ratio (P/E)= 22/5,100,000/(870,000) = 22/5.8621 = 3.7529
New Earnings per share after share buyback (EPS)= 5,100,000/(870,000 -75,000) = 5,100,000/795,000 = 6.4151
Price per share = (P/E) * New EPS = 3.7529 * 6.4151 = 24.08
2. Option b iand c are correct options
A repurchase can remove a large block of stock that is overhanging the market and keeping the price per share down.
When a firm distributes cash by repurchasing stock, stockholders have the option to either sell or not sell stock.
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