Assume par value per common stock of equity be $1.
Equity before buyback = 2,500 shares * $1 = $2,500
Debt-Equity ratio before buy back = 1
Debt = Equity = $2,500
Weight of debt = Weight of equity = $2,500 / $5,000 = 0.50
WACC = (14%*0.50) + (3%*0.50) = 8.50%
The WACC shall remain same after buyback.
Equity after buyback = (2,500 – 900)*$1 = $1,600
Debt after buyback = $2,500
Debt+Equity = $1,600 + $2,500 = $4,100
Weight of equity = $1,600/$4,100 = 0.3902
Weight of debt = $2,500/$4,100 = 0.61
Weighted cost of debt = 3%*0.61 = 1.83%
Weighted cost of equity = WACC – Weighted cost of debt
= 8.50%-1.83%
= 6.67%
Cost of equity after buyback = Weighted cost of equity/Weight of
equity
= 6.67% /0.3902
= 17.09%
New Return on equity after the buy-back = 17.09%.
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