Consider the case of Gadgetron Inc.: Gadgetron Inc. has forecasted a net income
ID: 2621287 • Letter: C
Question
Consider the case of Gadgetron Inc.:
Gadgetron Inc. has forecasted a net income of $4,200,000 for this year. Its common stock currently trades at $21 per share, and the company has 790,000 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 85,000 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 Gadgetron Inc.'s expected share price after the stock repurchase?
A) $22.36 per share
B) $23.54 per share
C) $25.89 per share
D) $27.07 per share
2.) Which of these factors are considered an advantage of a stock repurchase? Check all that apply.
A) Repurchases can be used to produce large-scale changes in capital structure.
B) The price of the firm’s stock might benefit more from cash dividends than from a repurchase.
C) A repurchase can remove a large block of stock that is overhanging the market and keeping the price per share down.
Explanation / Answer
P/E ratio = MPS/EPS
EPS = 4200,000/790,000 = 5.316
Current P/E Ratio = 21/5.316 = 3.95 times
Net Income = 4200,000
Shares Bought back 85000
Remaining Shares = 705,000
New EPS = 4200,000/705,000 = 5.957
MPS = EPS*P/E Ratio
= 5.957*3.95 = $23.54 per share (approx)
Hence, B
2. A) Repurchases can be used to produce large-scale changes in capital structure.
C) A repurchase can remove a large block of stock that is overhanging the market and keeping the price per share down.