Note : |
Following calculations are made on the basis of best assumptions can be made as per the information provided in given problems. The answer might be different as answers provided by other expert on the basis of different assumptions taken by other expert. |
Relevant information | |
Stock Beta (By) | = 0.60 |
Expected Return of Stock - E(R) | =13% |
Risk Free Rate of Return (Rf) | =4.5% |
Repurchase of stock (Buy back) | =20% |
Ans (a) | Beta after transaction | ||
Existing Beta of stock | = 100*0.6/100 | ||
=0.60 (as given) | |||
Note : Is is assuming that amount received from issued of risk free debt is equal to repurchase of stock then, | |||
Note 2 : as we know that beta of risk free security is 0 | |||
Hence, | |||
Beta after transaction = | (100-20)*0.6+(20*0)/100 | ||
= | 0.48 |
Ans (b) | Expected Return of stock aster transaction | |
Since expected return can be calculated as per CAPM (Capital assets pricing model) as follows : | ||
Expected return before repurchase-E( R) | =Rf + (Rm-Rf)B | |
Where, | ||
B | = 0.60 | |
Rm , market risk premium | ? | |
Rf | =4.5% | |
E( R) | =13% | |
Hence, | ||
13% | =4.5% +(Rm-4.5%)0.60 | |
13% | =4.5% + 0.60 Rm -2.7% | |
Rm | = 18.67% | |
Hence, expected return on beta after above transaction as per CAPM shall be : | ||
=4.5% + (18.67-4.5)0.48 | ||
=11.30% |
Ans ( c) | Relevant Data | |
Amount in "$" | ||
Expected Earnings per share | 4.5 | |
P/E Ratio | 13 times | |
Let, Number of shares of the company | =100 | |
Let, Risk free debt issued | =20 | |
Hence, Expected earning before above repurchase transaction | =4.5*100 | |
=450 | ||
Expected earning after repurchase | =450- (20*4.5%) | |
(earning - coupon amount on risk free debt e.i. 20*4.5%) | =450- 0.9 | |
=449.1 | ||
No. of shares after above repurchase transaction | =100-20 | |
=80 | ||
Hence, Earning per share after repurchase transaction | =449.1/80 | |
=5.6138 per share |
Explanation : since earning per share of company increase and shareholders will get more returns in form of earning and dividend, wealth of shareholders will get increased |
Change in shareholders market price (assuming boot strap effect of P/E ratio i.e. taking P/E Ratio before the transaction for calculation of market price after above transaction) |
share Price before above transaction | =4.5*13 |
=58.5 per share | |
Share price after above transaction | =5.6138*13 |
=72.78 per share |
Explanation : since share price increased due to above transaction, the benefits of appreciation in share will benefit the shareholder in form of capital gain. Hence, it will benefit the shareholder when they will sell their shares. | |||||
Correct answer : | |||||
(D) You can not tell. It depends on the shareholder's risk preference. Cash flows are higher, but so is risk, some of the shareholder will be better off,some will be worse off. |
Ans ( d) | Where share price is same as before the above transaction i.e. 13*4.5=58.5, then P/E ratio shall be | |||||
P/E ratio after repurchase | =58.5/5.6138 | |||||
(market price/EPS) | =10.42 times | |||||
Explanation: Since P/E Ratio get decreased, there is value loss for shareholders in the market. | ||||||
Correct answer : | ||||||
(B) it is not reasonable and reflect the value loss of the recapitalization. |
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