Describe Corporate Governance
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A company may choose to carry out its share repurchase program using surplus cash that it has. Alternatively, it may choose to borrow money and use debt to finance the repurchase. Either method will impact the company’s earnings per share (EPS).
Using Excess Cash
When a company uses excess cash to finance its share repurchases, earnings per share usually increase. This is because net income remains unchanged while the number of outstanding shares reduces after the share repurchase.
The extent of the increase in the EPS is dependent on the price at which the shares are repurchased. This notwithstanding, the increase in EPS is only possible if the cash used to repurchase the shares would not earn its cost of capital if it were to be retained by the company.
Example
Using the information in the table below, what is Company A’s EPS after a share repurchase which uses cash, if the company uses $14,000,000 of cash to repurchase shares at $14 per share?
| Company A’s Financials | Before the share repurchase | After the share repurchase |
| Net Income ($): | 1,500,000 | 1,500,000 |
| Shares Outstanding: | 3,000,000 | ? |
| Share price ($): | 13.00 | ? |
| EPS ($): | 0.50 | ? |
Solution
The number of shares repurchased = $14,000,000/$14 = 1,000,000 shares
Company A will therefore have 3,000,000 – 1,000,000 = 2,000,000 shares outstanding after the share repurchase.
Since net income remains unchanged, EPS after the share repurchase = $1,500,000/2,000,000 = $0.75
Using Debt financing
When debt is used to repurchase shares, the debt comes at a cost. Therefore, EPS will only increase if the earnings yield i.e. earnings per share or price per share, is greater than the after-tax cost of debt.
Whenever the after-tax cost of debt is equal to the earnings yield, EPS will remain the same. However, if the after-tax cost of debt exceeds the earnings yield, EPS will decline.
Example
Using the information in the table below, what is Company A’s EPS after a share repurchase assuming that the after-tax cost of debt is 6% if the company uses $14,000,000 of cash to repurchase 1,000,000 shares at $14 per share?
| Company A’s Financials | Before the share repurchase | After the share repurchase |
| Net Income ($): | 1,500,000 | 1,500,000 |
| Shares Outstanding: | 3,000,000 | 2,000,000 |
| Share price ($): | 13.00 | ? |
| EPS ($): | 0.50 | ? |
| Earnings yield (%) | 3.85 | ? |
Solution
EPS after the share repurchase = (Earnings – after-tax cost of debt)/outstanding shares after repurchase = [$1,500,000 – ($14,000,000 x 0.06)]/2,000,000
= [$1,500,000 – $840,000]/2,000,000
= [$660,000]/2,000,000
= $0.33
Company A’s EPS is therefore less than it was prior to the repurchase. This is not surprising given that the earnings yield before the repurchase is 3.85%, which is less than the after-tax cost of debt, 6%.
Question
A company uses debt financing for the repurchase of its shares. If the after-tax cost of borrowing is equal to the earnings yield before the repurchase, which of the following statements accurately describes what will happen to the company’s EPS after the repurchase?
A. EPS will increase
B. EPS will be unchanged
C. EPS will decrease
Solution
The correct answer is B.
If a company’s after-tax cost of debt is equal to the earnings yield before the repurchase, its EPS will remain the same.
Reading 38 LOS 38d:
Calculate and compare the effect of a share repurchase on earnings per share when 1) the repurchase is financed with the company’s excess cash and 2) the company uses debt to finance the repurchase
Sergio Torrico
2021-07-23
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2021-07-17
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