Question

i. ii Companies reward their shareholders in two main ways - by paying dividends or by buying back shares of stock. An increasing number of blue chips, or well-established companies, are doing both Paying dividends and stock buybacks make a potent combination that can significantly boost shareholder returns AMC Corporation currently has $400 million of fixed assets and $100 million in excess cash. The firm has 10 million shares outstanding and no debt. Suppose AMC uses its excess cash to repurchase shares. After the share repurchase, news will come out that will change AMC's fixed asset value to either $600 million (good news) or $200 million (bad news). Evaluate under which conditions an increase in the dividend payment can be interpreted as a signal of good news or bad news. (5 marks) Analyse how an announcement of a share repurchase is considered a positive signal. (5 marks) iii. Suppose AMC management expects good news to come out. If management desires to maximize AMC's ultimate share price, suggest whether they should undertake the repurchase before or after the news comes out? (4 marks) iv. Recommend when would management undertake the repurchase if they expect bad news to come out? (4 marks) Rationalise the effect would you expect an announcement of a share repurchase to have on the stock price. (3 marks) vi. Deduce the impact of an announcement of a share repurchase to have on the stock price for AMC. (4 marks) v.

Answer 1

Ans i) When the increase in dividend is coupled with the increase in sales, net income and the increase in net fixed assets and net investments and capital expenditure, that would be a good signal as Market will sense that the company's earnings are on a growing path , more investments and expansions are following that will enhance the future earnings further.

However, when there is dividend increase but overall decrease in capital expenditure and sales and earnings are reducing , that would indicate a bad signal. In this case the market will sense the declining stage of the company with no available plan for expansion projects , no sales growth opportunities and the dividend is being paid out from retained earning to keep the market happy , but actually the company has no investment avenue.

Ans ii) A share repurchase is a good new for the investors and that would reduce the number of shares outstanding and the earning per share will improve which will lead to higher return and higher share price.

Ans iii) If AMC Management is expecting a good news , the share price will increase after the good news comes out. In that case it would be able to repurchase lesser number of shares than before the good news. So for the maximum benefit of shareholders AMC should repurchase before the good news so that it can repurchase maximum number of shares and the EPS of the investors after the repurchase will be maximized.

Ans iv) The management may want to repurchase even when a bad news to come out. When there is a chance of a hostile take over as a result of the bad news , the promoter may want to repurchase shares from market so that the overall no of outstanding shares comes down and the holding of promoter becomes a comfortable majority which can stave off any hostile take over bid.

Ans v) An announcement of share repurchase will give the signal of higher EPS in the near future for the investors, so the share price will increase in general.

Ans vi) After the share repurchase the stock price will increase in anticipation for the higher EPS. However, if the bad news of reduction of fixed asset comes after that, the share price will decrease to absorb the possibility of lower future income and in case the good news of the increase of fixed assets comes after share repurchase, the share price will increase further in anticipation of even higher returns in future.