Lesson 8 of 9
Since the company uses its own cash or borrows money to buy back shares, share repurchases impact the financial statements. In general, the assets and shareholders' equity falls, and the leverage increases.
Impact on Earnings Per Share
After repurchase, the number of shares outstanding will fall. The changes in earnings will decide whether the EPS will rise or fall. If the company uses its own funds, the earnings will fall. If the company uses borrowed funds, it will incur interest costs, the earnings will reduce equivalent to the after-tax cost of borrowed funds.
An intuitive approach is to compare the earnings yield (EPS/Price per share) with the after-tax yield on own funds or after-tax cost of borrowed funds. If earnings yield is higher, EPS will rise and vice verse after repurchase.
Let's take an example to understand this. Assume that a company's share price at the time of buyback is $100 and its EPS is $7. The company borrows funds to repurchase shares. The after-tax cost of borrowed funds is 10%.
The company's earnings yield before buyback is $7/$100 = 7%. Since the earnings yield before buyback is lower than the after-tax cost of borrowed funds, the EPS will fall after repurchase.
Impact on Book Value per Share
The impact of share repurchase on Book Value per Share will be as follows:
If Market Price per Share is greater than Book Value per Share, Book Value per Share will decrease.
If Market Price per Share is less than Book Value per Share, Book Value per Share will increase.
This happens because the shares are repurchased at or above the market value, so when the market price is more than the book value, more money is spent to buy shares having less value which erodes the book value for remaining shares.