In a world with perfect capital markets, a firm that issues a large amount debt to finance a share repurchase will ultimately boost its EPS and reduce its post-transaction market capitalization, but will not affect its stock price.

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BlackTom AI · Accepted Answer

Question restatement: The statement asks whether, in a world with perfect capital markets, a firm that issues a large amount of debt to finance a share repurchase will boost its EPS and reduce its post-transaction market capitalization, but will not affect its stock price.
Option 1: True. This option asserts three things at once: (a) EPS will be boosted by debt-financed buybacks, (b) post-transaction market capitalization will be reduced, and (c) stock price will be unaffected. While (a) EPS can rise when the firm repurchases shares (fewer shares outstanding can lift earnings per share if net income is not reduced proportionally), the other two claims are not jointly consistent with the Modigliani–Miller framework. In a world with perfect capital markets and no taxes, the total value of the firm is unchanged by capital structure changes. The equity value (and thus post-transaction market capitalization) should reflect the new leverage but remains tied to the firm’s overall value; simply issuing debt to finance a buyback does not guarantee a reduced equity value in the sense implied, and crucially, the stock price would respond to the levered risk and altered cash flows. Therefore, asserting that stock price remains unchanged is problematic, and the combination of outcomes in this statement is not supported by the standard theory. This makes the statement as a whole incorrect.
Option 2: False. This option contends that the described scenario does not occur as stated. Under perfect capital markets, changing capital structure by issuing debt to finance a share repurchase changes the mix of debt and equity but leaves the overall firm value unchanged. EPS can rise due to fewer shares outstanding, and the post-transaction equity value (and thus market capitalization) adjusts in line with the new leverage. Most importantly, the stock price per share is expected to reflect the new risk and cash-flow characteristics; it is not guaranteed to stay the same. Therefore, the combination described in the statement—EPS boost with a reduced post-transaction market capitalization, and no change in stock price—is not consistent with the standard implications of perfect capital markets. This makes the claim false.
Option 1 deeper dive: Why the EPS gain does not guarantee the other outcomes? A higher EPS arises from fewer shares, but market capitalization behavior depends on the total value of the equity, which in turn depends on how the market prices the levered equity. In a perfect market, price per share adjusts to preserve consistency with total value and leverage, so assuming the price stays flat while the number of shares falls is not generally correct. The implicit assumption that stock price is insulated from the leverage shift violates the intuition that risk and cash-flow profiles shift with debt.
Option 2 deeper dive: Why the asked combination is unlikely? If debt issuance finances a buyback, the company’s leverage changes and the equity portion bears more risk. In a perfect market, investors would reprice the equity to reflect this higher risk, typically altering the stock price, and the equity value would adjust accordingly. Thus the claim that stock price remains unchanged while market capitalization changes is not supported by the theoretical framework.
Summary: The statement as a whole makes at least one incorrect claim about stock price behavior under perfect capital markets, and therefore the overall proposition is not accurate.

COMM_V 370 101-108 2025W1 COMM 370 - 2025W1 - Final - Requires Respondus LockDown Browser

In a world with perfect capital markets, a firm that issues a large amount debt to finance a share repurchase will ultimately boost its EPS and reduce its post-transaction market capitalization, but will not affect its stock price.

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