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Question:
A firm with earnings per share of $2 decides to repurchase a portion of its shares at their market price of $25. The firm’s after-tax cost of debt is 6% and the firm earns a 2% after-tax yield on its excess cash. When the firm repurchases shares, its earnings per share will:
A
increase if the firm funds the repurchase with debt or uses excess cash to repurchase the shares.
explanation
The earnings yield on the firm’s shares is $2 / $25 = 8%. Because both the firm’s after-tax yield on excess cash and its after-tax cost of borrowing are less than the earnings yield, financing a share repurchase either with excess cash or with debt will increase earnings per share.
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