A firm with a return on common equity (ROCE) of 30% has financial leverage of 37.5% and a net after-tax borrowing cost of 5% on $240 million of net debt. 

Required:

(a) What rate of return does this firm earn on its operations?

(b) The firm is considering repurchasing $150 million of its stock and financing the repurchase with further borrowing at a 5% after-tax borrowing cost. What effect will this transaction have on the firm's return on common equity if the same level of operating profitability is maintained?

(c) Will this repurchase change the per share intrinsic value of the equity? Why? No effect. Share buys and borrowing are zero NPV transactions: they don't add value. Provision: if shares are mis-priced, share repurchases will affect value.

(d) Will the normal P/E ratio for this firm change because of this transaction? Why?

(e) Would you expect the earnings-per-share growth rate to change after the repurchase transaction? Why?

Answer rating: 100% (QA)

SOLUTION a The rate of return ... View the full answer