Workspace /E3 Payout & Leverage Effects
E3

Payout & Leverage Effects

Run a repurchase, a special dividend or a higher regular dividend through the latest year of a sample company, and compare EPS, book value per share, leverage, FCFE, dividend cover and WACC before and after.

Learning focus: A payout can move EPS a long way while the business stays worth what it was, so EPS accretion and value have to be read apart.

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1. The action
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2. Cost of the funding
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3. WACC
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4. Target payout
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The action
Action
Repurchase with new debt
Amount
$75.4m
Half the latest year's cash
Repurchase price
$44.50
0.00% premium
Shares repurchased
1.694m
Repurchase price to book
2.89×
Below 1× lifts book value per share. Above 1× lowers it.
Income forgone after tax
$2.9m
Interest on the new debt
Tax rate used
24.00%
Before and after
MeasureBeforeAfterChange
Shares97.142m95.448m−1.694m
Net income$253.9m$251.0m−$2.9m
EPS$2.61$2.63+$0.02
Book value per share$15.41$14.90−$0.52
Dividend per share
Held still, so the total falls with the shares
$2.05$2.05No change
Net debt$879.2m$954.6m+$75.4m
Net debt to EBITDA1.81×1.96×+0.16×
Interest cover9.03×8.28×−0.75×
FCFE
Recurring, without the one-off borrowing
$207.8m$204.9m−$2.9m
FCFE with the new debt counted
The year of the borrowing only
$207.8m$280.3m+$72.5m
Dividend coverage on net income1.27×1.28×+0.01×
Dividend coverage on FCF0.82×0.82×No change
Cost of equity
Re-levered to the new debt weight
8.00%8.05%+0.05 points
Debt weight19.24%20.65%+1.41 points
WACC7.19%7.17%−0.02 points

The first full year after the action, on year-end shares. Book value is taken at the moment of the payout.

EPS and book value per share
Rule of thumb: earnings yield against the cost of funding
Earnings yield
5.87%
EPS over the repurchase price
After-tax cost of debt
3.80%
5.00% before tax
After-tax yield forgone on cash
2.66%
The hurdle when cash pays for it
EPS test
Adds to EPS
Earnings yield against the after-tax cost of debt

A debt-funded repurchase adds to EPS when the earnings yield exceeds the after-tax cost of debt. With cash, the hurdle is the after-tax yield forgone. Here 5.87% exceeds 3.80%. The rule speaks only to EPS, not to value.

EPS is not value

The value of the firm does not rise just because EPS rose. Paying out cash or swapping equity for debt changes who holds the claims and how risky they are, not what the business earns. So the value lines below hold the business still, leaving out any tax saving on new interest and any cost of financial distress. A repurchase adds to value per share only if the shares are bought below what they are worth.

MeasureBeforeAfterChange
Equity value$4,322.8m$4,247.4m−$75.4m
Enterprise value$5,202.0m$5,202.0mNo change
Value per share$44.50$44.50No change
P/E17.03×16.92×−0.11×
Dividend safety
Dividend safety
At risk
Dividends after
$195.9m
$199.4m before

FCF of $159.9m covers the dividend of $195.9m 0.82×. The gap has to come from cash or new debt, which can't go on for long. Net income coverage of 1.28× hides this, because dividends are paid in cash.

Target payout
Last dividend used
$2.05
EPS used
$2.63
EPS after the action
Target payout used
78.54%
Gap to target
$0.02
Expected dividend
$2.06
Moves part of the way to target
Constant payout dividend
$2.07
Pays the target in full every year

EPS: $2.61 to $2.63, a change of 0.63%, because the earnings yield of 5.87% is above the after-tax cost of debt of 3.80%. Value: that is arithmetic, not value. The business is the same, and each share is still worth $44.50. The P/E moves from 17.03× to 16.92×, so a change in EPS is met by a change in the multiple. Leverage: net debt to EBITDA moves from 1.81× to 1.96×.