5. Stock repurchases Overholser Inc. has forecast net income of $8,000,000 over

Question

5. Stock repurchases Overholser Inc. has forecast net income of $8,000,000 over the next year. Overholser also forecasts a capital budget of $8,000,000 for the year. If the firm maintains its capital budget of 50% equity and 50% debt, how much of a dividend can Overholser pay if it follows a strict residual dividend policy? $5,000,000 $9,000,000 $7,000,000 $8,000,000 $4,000,000 Instead of paying a cash dividend, Overhoiser is considering a stock repurchase. The firm currently has 1,500,000 shares of common stock outstanding that have a current market price of $80 per share. If Overholser carries out the repurchase, it expects to be able to buy the stock at its current market price. What is Overholser's current price-to-earnings (P/E) ratio? 14.00 11.00 15.00 12.00 13.00 If Overholser has the amount predicted by the residual dividend model available to pay to shareholders, how many shares can it repurchase? 25,000 shares 62,500 shares 87,500 shares 50,000 shares 37,500 shares If the firms P/E ratio is expected to be the same after the repurchase, what is Overholser's expected stock price after the repurchase? $84.21 $87.14 $86.25 $82.76 $85.71

Explanation / Answer

Part A :

A company has a earning of $8,000,000 and capital budget of $8,000,000 and maintains the debt equity ratio to be 1:1 that is 50% debt and 50% equity. Company have the project capital requirement of $8,000,000 and in order to maintain debt equity ratio to 1:1 company has to pay one by two from debt and one by two from equity. In other words company has to borrow $4,000,000 and use $4,000,000 to maintain 1:1 ratio leaving the residual amount of $4,000,000 i.e; $8,000,000 - $4,000,000 which is our amount of dividend.

Part B

In order to calculate PE ratio we need to find the earning per share which can be calculated by the following formula = Net earnings / number of outstanding share

= $8,000,000 / 1,500,000 = $5.33

When we have earning per share the PE ratio would be calculated by the following formula

PE ratio = Current market price / Earning per share = $80 / $5.33 = 15

PE ratio = 15

Part C :

After predicting the amount of dividend we can calculate the number of shares company can repurchase by the following formula

Number of share the company can repurchase = Total Dividend amount / price per share

                                                                                = $4,000,000 / $80 = 50,000

Therefore company can repurchase 50,000 shares.

Part 4 :

In order to find the expected stock price after the repurchase we need to calucate the Earning per share of the remaining share = Net earnings / number of outstanding share

Now we have the number of outstanding share as 1,500,000 - 50,000 = 1,450,000

So the EPS after the repurchase would be = Net income / Outstanding share = $8,000,000 / 1,450,000 = $5.51

Our new EPS after repurchase is $5.51

Keeping the PE ratio at 15 the expected stock price after repurchase can be calculated with the below formula =

EPS * PE ratio = $5.51 * 15 = $82.76

Therefore our Expected stock price after repurchase = $82.76.

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