Alex, Inc. is ﬁnanced 100% with equity. The ﬁrm has 100,000 shares of stock outstanding with a market price of $5 per share. Total earnings for the most recent year are $50,000. The ﬁrm has
Cash of $25,000 in excess of what is necessary to fund its positive NPV projects. The ﬁrm is
Considering using the cash to pay an extra dividend of $25,000 or, alternatively, to repurchase
$25,000 of stock. The ﬁrm has other assets worth $475,000 (market value). For each of the
Questions that follow, assume there are no transaction costs, taxes, or other market imperfections.
Assume the ﬁrm uses the $25,000 excess cash to buy back stock at $5 per share. What will be the
Market price per share of Alex's stock after the repurchase?

Question

Quizplus · Accepted Answer

If the firm uses the $25,000 excess cash to buy back stock at $5 per share, it will repurchase 5,000 shares ($25,000/$5). This will leave 95,000 shares outstanding. The total earnings of the firm will remain $50,000. Therefore, the earnings per share (EPS) will increase from $0.50 ($50,000/100,000) to $0.53 ($50,000/95,000). 
The price-earnings (P/E) ratio of the firm will stay the same as the market price of the stock and the total earnings of the firm have not changed. 
Therefore, the market price per share of Alex's stock after the repurchase will be $5.25 (P/E ratio of 10, which is the original P/E ratio of $5 market price and $0.50 EPS, multiplied by $0.53 EPS after repurchase).

The best choice is to repurchase the stock as it will increase EPS and potentially increase the market price per share. An extra dividend will not have an impact on the market price per share.

Alex, Inc Is ﬁNanced 100% with Equity