XYZ Inc., a publicly traded company, has the following characteristics:
a. 100 million shares trading at $ 10 a share. (Market cap = $1000)
b. A cash balance of $ 200 million, earning 2% a year annualized.
c. Total net income of $ 40 million (giving the company a PE ratio of 25 today).
XYZ Inc. uses its cash balance of $ 200 million to buy back shares. What will happen to the share price after the transaction?
a. It will go up
b. It will go down
c. It will remain unchanged
Classic corporate finance question, right? Let’s see what the answer will be at the two limiting extremes: an extremely ”lazy” market and a completely rational one.
a. Markets are really lazy: Here is how it goes. Assuming that you can buy the shares back at the current price (unrealistic, but you have to start somewhere), you will buy back 20 million shares with the $ 200 million, reducing the number of shares to 80 million. The loss of the income on the cash (2% of 200 million = $ 4 million) will reduce net income by $ 4 million to $ 36 million……………