2. The Mechanics

2.3. Summary and Discussion

The following table summarizes the three forms of distribution that we have considered in the preceding sections (dividend, open market buyback and fixed-price tender offer):

  • The first part of the table lists the post-announcement effects
  • The second part summarizes the details of the recapitalization
  • The third part describes the valuation after the recapitalization
  • At the bottom of the table, we show total shareholder value added as well as the earnings implications of the recapitalization.

  

    Dividend Open market repurchase Tender offer
(1) Post-announcement (')
Levered firm value VL' 4'125 4'125 4'125
- Net debt outstanding D' 0 0 0
Equity value EL' 4'125 4'125 4'125
Shares outstanding N 500 500 500
Share price P' 8.25 8.25 8.25
     
(2) Recapitalization    
Additional borrowing New debt 2'500 2'500 2'500
Distribution to shareholders Total payout 2'500 2'500 2'500
Repurchase price PR   8.25 10
Repurchased shares NR   303 250
     
(4) After the recapitalization (*) 
Levered firm value VL* 4'125 4'125 4'125
- Debt outstanding D* 2'500 2'500 2'500
Equity value EL* 1'625 1'625 1'625
Shares outstanding N* 500 197 250
Share price P* 3.25 8.25 6.50
     
Shareholder value added   875 875 875
Net income   227.5 227.5 227.5
Earnings per Share EPS 0.46 1.15 0.91

 

The main takeaways are:

  • All three recapitalization alternatives produce the same total shareholder value added, namely an additional DTS of 875. They also produce the same market value of equity (E*) and the same overall firm value (VL*). From the point of view of the company valuation, the forms of distribution are therefore equivalent.
     
  • The source of added value is the debt tax shield that the firm's additional borrowing brings about. The distribution decision itself does not affect shareholder wealth!

  • However, the distribution method affects the number of shares outstanding as well as the stock price:
    • With a dividend payment, the number of shares outstanding remains the same. After the recapitalization, the same number of shareholders have to share a smaller equity value, which is why the share price decreases after the dividend payment.
    • The open market share repurchase program leaves the share price unaffected and the number of shares drops.
    • The fixed-price tender offer we have considered is associated with both a lower share price and a lower number of shares. The share price ultimately drops because the repurchase price (PR) exceeds the post-announcement stock price (P'). 
       
  • Because the forms of distribution have vastly different implications for the remaining number of shares outstanding but do not affect aggregate firm-level values (including net income), the resulting earnings per share (EPS) also vary greatly:
    • Remember that the unlevered firm's EPS were 0.78.
    • Not surprisingly, the payout decision that leads to the largest reduction in the number of shares outstanding has the greatest positive impact on EPS. After the open market share repurchase program, EPS increases to 1.15 whereas a dividend payment lowers EPS to 0.46. Yet all payout forms considered have the same implications on shareholder value!
    • It therefore follows that EPS is a flawed performance metric. There is NO causal relation between EPS and shareholder value!
    • In reality, unfortunately, many managers and market participants put great emphasis on EPS. We will get back to this issue and the misbelief that EPS is a value indicator later in this section.