Reading 33- LOS l ～ Q1－2

1.Belden Engineering Corporation (BEC) is considering a share repurchase program. David Gudzanski, the firm’s executive vice president prepares a memo to the board of directors detailing reasons why a share repurchase would be favorable at this time. Reasons listed in the memo are as follows:

Reason 1: The resulting capital structure from the share repurchase would be more favorable for investors in BEC’s bonds.

Reason 2: BEC’s stock is currently selling at $37 in the marketplace. Our discounted cash flow analysis values the company at $48 per share.

Reason 3: The share repurchase could be used to offset dilution caused by the exercise of employee stock options.

Reason 4: BEC can use the repurchase to send a signal to investors that management has a positive future outlook for the company.

Reason 5: The share repurchase could be used to implement a residual dividend policy while diminishing the potential increase in perceived risk that such a policy would cause for investors.

Which of Gudzanki’s reasons in favor of the share repurchase are TRUE?

A)   Reasons 1 and 3 only.

B)   Reasons 1, 2, and 4.

C)   Reasons 2, 3, 4, and 5.

D)   Reasons 2 and 3 only.

The correct answer was C)

A share repurchase would decrease the percentage of equity in a firm’s capital structure, which would in turn increase the percentage of debt. An increase in debt would add more leverage to the firm which would be negative for the firm’s bondholders. The other reasons listed are all rationales for a share repurchase.

2.All of the following are reasons for a stock repurchase EXCEPT:

A)   the corporation may purchase its shares at a bargain.

B)   repurchases can be used to decrease supply of the stock, thus increasing the share price.

C)   repurchases can be used to produce significant changes in capital structure.

D)   investors see repurchases as a signal that shares are overvalued.

The correct answer was D)

Repurchases are viewed as a signal by the company that shares are undervalued - worth more than their going price. Shareholders who do not believe the shares are worth more can sell them, while more-supportive shareholders can retain share ownership. A company can also use share repurchases to alter their capital structure by changing the mix of debt and equity.