The Rumpel Felt Co.was all equity financed.It recently borrowed money and used the funds to repurchase shares.The stock price rose as a result.Which of the following explains the increase in stock price?
I.The tax shields generated by the new debt
II.A reduction in agency costs due to the interest on the debt
III.A generous premium included in the repurchase price

Question

Quizplus · Accepted Answer

The tax shields and the reduction in agency costs will both increase the stock price. However, a premium in the repurchase price reduces the stock price after the repurchase. For example, consider a company with two shares outstanding trading at $10 per share. If one shareholder borrows to buyout the other for $19, then is the remaining share worth more than $10? No. It is worth less.