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Unformatted text preview: om, Campbell Soup, and
Hasbro Companies. “Taking
money out of a business during a
period of economic weakness is
risky,” says John Puchalla, an
economist for Moody’s.
Sources: Russ Banham, “The Buyback
Catch,” CFO (March, 2001), downloaded from
www.cfo.com; David Henry “Flocking to Dividends,” Business Week (June 18, 2001),
pp. 144–145; Anne Tergesen, “When Buybacks Are Signals to Buy,” Business Week
(October 1, 2001), p. 94. earnings per share and therefore the market price per share. In addition, certain
owner tax benefits may result. The repurchase of common stock results in a type
of reverse dilution, because the EPS and the market price of stock are increased
by reducing the number of shares outstanding. The net effect of the repurchase is
similar to the payment of a cash dividend.
EXAMPLE Benton Company, a national sportswear chain, has released the following financial data:
Earnings available for common stockholders
Number of shares of common stock outstanding
Earnings per share ($1,000,000 400,000)
Market price per share
Price/earnings (P/E) ratio ($50 $2.50) $1,000,000
20 The firm wants to use $800,000 of its earnings either to pay cash dividends or to
repurchase shares. If the firm paid cash dividends, the amount of the dividend
would be $2 per share ($800,000 400,000 shares). If the firm paid $52 per
share to repurchase stock, it could repurchase approximately 15,385 shares
($800,000 $52 per share). As a result of this repurchase, 384,615 shares CHAPTER 13 Dividend Policy 577 (400,000 shares 15,385 shares) of common stock would remain outstanding.
Earnings per share (EPS) would rise to $2.60 ($1,000,000 384,615). If the
stock still sold at 20 times earnings (P/E 20), its market price could be estimated
by multiplying the new EPS by this P/E ratio (the price/earnings multiple
approach presented in Chapter 7). The price would therefore rise to $52 per
share ($2.60 20). In both cases, the stockholders would receive $2 per share: a
$2 cash dividend in the dividend case or a $2 increase in share price ($50 per
share to $52 per share) in the repurchase case.
Besides the advantage of an increase in per-share earnings, certain owner tax
benefits also result. If the cash dividend were paid, the owners would have to pay
ordinary income taxes on it, whereas the $2 increase in the market value of the
stock that resulted from the repurchase would not be taxed until the owner sold
the stock. Of course, when the stock is sold, the capital gain is taxed, but possibly
at a more favorable rate than the one applied to ordinary income. The IRS is
alleged to monitor firms that regularly repurchase stock and levies a penalty when
it believes repurchases have been made to delay the payment of taxes by
stockholders. Accounting Entries
The accounting entries that result when common stock is repurchased are a
reduction in cash and the establishment of a contra capital account called “treasury stock,” which is shown as a deduction from stockholders’ equity. The label
treasury stock is used on the balance sheet to indicate the presence...
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