3. Coping with Excess Cash

3.1. Example

In what follows, we consider the hypothetical computer manufacturer "Pear," which has the following characteristics:

  • Market value of equity (E): 600 billion
  • Shares outstanding (N): 6 billion (--> Stock price (P) of 600/6 = 100)
  • Interest bearing debt: 0
  • Excess cash: 150 billion
  • Cost of equity (kE) under the current financing policy: 10%
  • Cost of debt (kD, interest earned on excess cash): 2%
  • Tax rate (τ): 30%
  • EBIT: 82.7143 billion

 

Now let's assume the following:

  • The market currently expects the firm to maintain a cash balance of 150 billion "forever." Accordingly, the firm pursues a financing policy with constant debt levels.
  • "Pear" surprises the market by announcing a massive share repurchase program, in which it will borrow 100 billion "forever" at the cost of debt of 2% to repurchase 250 billion worth of shares (using up all excess cash) at a price of 125 each.

 

Let's walk through the analysis step by step. The details of the analysis are summarized in the Excel file "Pear recapitalization." This file should also serve as a useful template for similar investigations.