An all equity firm generates cash flows (CFFA) of $100 million every year in per

Question

An all equity firm generates cash flows (CFFA) of $100 million every year in perpetuity. Based on the risk of the cash flows, a discount rate of 20% is appropriate for the firm. The firm is considering a project that will require an investment of $75 million in one year. The project will generate cash flows of $10 million in perpetuity. The project is as risky as the firm and investment in the project will be made from cash generated by the firm. Therefore, dividends in one year will be reduced. The first cash flow will be received a year after making the investment. If the firm has 10 million shares outstanding, what is the stock price before the firm makes a decision to invest in the project? What will the stock price be if the firm announces that it has decided to take the project? Is the company making the right decision?

Explanation / Answer

Solution :

The stock price before the firm makes a decision to invest in the project =Market value of the firm/No of shares outstanding

The stock price before the firm makes a decision to invest in the project = $ 100,000,000/10,000,000

The stock price before the firm makes a decision to invest in the project = $ 10

The market value of the firm immediately after making the investment announcement = $ 100 million - $ 75 million ( $ 25 million)

Stock price of the firm = $ 25,000,000/10,000,000

Stock price of the firm =$ 2.5

The company is making the right decision by investing in the project because even though the stock price is down at the time of investment into the new project , the stock price will rise in subsequent years because of the cash inflows of $ 10 million in perpetuity from next year after the investment.

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