# Stock Repurchase And

Document Sample

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Chapter 15. Tool Kit for Distributions to Shareholders: Dividends and Repurchases

SETTING THE TARGET DISTRIBUTION LEVEL: THE RESIDUAL DISTRIBUTION MODEL
(Section 15.7)

The optimal distribution ratio for a firm is a function of four factors. (1) Investors' preferences for dividends
versus capital gains. (2) The firm's investment opportunities. (3) Its target capital structure. And (4), the
availability and cost of external capital.

The last three elements can be combined into the residual distribution model. Within the residual model, firms
must determine the optimal capital budget, determine the amount of equity needed to fund the capital budget
(based upon the target capital structure), use reinvested earnings to meet equity requirements whenever possible,
and make distributions to shareholders only if more earnings are available than are needed for dividends. The
residual model can be expressed as:

Distributions = Net Income - [(Target equity ratio) * (Total capital budget)]
PROBLEM
Consider a firm whose net income for the current year is \$100 million, their target equity ratio is
60%, and the expected capital budget is \$50 million. What are its distributions to be made to
shareholders, according to the residual model?

Net Income                       \$100
Target equity ratio               60%
Total capital budget              \$50

Distributions   =           Net Income - [(Target equity ratio) * (Total capital budget)]
=      \$100          -           60%            *          \$50
=       \$70

Distribution    =               70.0%

What if the expected capital budget rose to \$166.67 million?

Total capital budget          \$166.67

Distributions   =      =    Net Income - [(Target equity ratio) * (Total capital budget)]
=      \$100          -           60%            *          \$167
=        \$0

Distribution    =                0.0%

The firm could not have a negative dividend, so a negative distribution must be a stock issue rather
than a stock repurchase. Under the residual policy, if investment opportunities exceed net income,
the firm should pay zero dividends and issue stock (or else increase its debt ratio to fund the
investment opportunities).
SECTION 15.7
SOLUTIONS TO SELF-TEST

2 Hamilton Corporation has a target equity ratio of 65%. Its capital budget is \$2 million. If Hamilton has
net income of \$1.6 million and follows a residual distribution model, how much will its distribution be?

Capital budget =                                \$2,000,000
Target equity ratio =                                 65%
Net income =                                    \$1,600,000

Residual distribution =                          \$300,000
n. If Hamilton has
distribution be?
SECTION 15.9
SOLUTIONS TO SELF-TEST

2 A firm has 2 million shares outstanding, with a \$20 per share market price. The firm has \$4 million in extra cash tha
to use in a stock repurchase; the firm has no other financial investments. What is the firm's value of operations and h
shares will remain after the repurchase?

n0 =                                                           2,000,000
P=                                                                   \$20
Extra cash =                                                  \$4,000,000

Vop =                                                       \$36,000,000

n=                                                            1,800,000

As a check:
Number shares sold =                                            200,000
n=                                                            1,800,000
has \$4 million in extra cash that it plans
firm's value of operations and how many
SECTION 15.13
SOLUTIONS TO SELF-TEST

5 Suppose you have 1,000 common shares of Burnside Bakeries. The EPS is \$6.00, the DPS is \$3.00, and the
stock sells for \$90 per share. Burnside announces a 3-for-1 split. Immediately after the split, how many
shares will you have, what will the adjusted EPS and DPS be, and what would you expect the stock price to
be?

Shares                                                1,000
EPS                                                      \$6
DPS                                                      \$3
Stock price                                             \$90
Split factor (n-for-1)                                    3

Shares                                                3,000

EPS                                                   \$2.00

DPS                                                   \$1.00

Price                                               \$30.00
PS is \$3.00, and the
plit, how many
the stock price to

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