Share buybacks are sometimes motivated by the desire to increase earnings per share. Falcon Ltd recorded an operating profit of $2 million in the last financial year. It has 4 million shares on issue and the market price of the shares is $5 each. Falcon announces that it will repurchase 10 per cent of each shareholder's shares at $5 per share.
a) Calculate Falcon's price-earnings ratio before the buyback.
b) An observer comments as follows: 'Falcon's buyback should boost its earnings per share from 50 cents to 55 cents, so with the price-earnings ratio remaining the same, the share price should increase'.
i) If the observer's argument is correct, what will Falcon's share price be after the buyback?
ii) Critically evaluate the observer's argument.