A company considers a new project with similar risk to its existing business. Th
ID: 2649068 • Letter: A
Question
A company considers a new project with similar risk to its existing business. The company estimates the project requires an investment, I = $100 million, and will generate a perpetual annual cash flow, EBIT = $20 million. The current financial date of the company are as follows:
Risk-free perpetual debt, D = $500 million
Equity, E = $300 million
Risk-free rate, Rf = 5%
Cost of Equity, Re = 15%
Number of shares, N0 = 10 million
Tax rate, t = 35%
a) Suppose the company proposes to fund the project by issuing new equity. If investors believe in the company estimate, what is the company share price after the announcement? How many shares will be issued?
b) If investors however believe that the project cash flow is only EBIT = $10 million; what will the share price be and how many shares does the company need to issue?
c) Suppose after the company had issues shares as in part b, new information emerges that convinces investors that the company investors are correct. What will be the share price now?
d) Suppose in part a, the company instead issues permanent, risk-free debt to finance for the project. What will the share price be if investors believe as in part b? What will share price be after the arrival of the new information mentioned in part c? Comparing with part c, what are the two advantages of debt financing in this case?
Explanation / Answer
Investment required = $ 100 million
Perpetual annual cashflow EBIT of new project = $ 20 million
Existing financial data
Risk free perpetual debt (D) = $ 500 million
Equity = $ 300 million
Risk free rate Rf = 5%
Cost of equity Re = 15%
Number of shares = 10 million
Tax rate : 35%
Answer a)
Current share price = Existing value of the equity / outstanding number of shares
= $ 300 million/ 10 million
= $ 30 per share
Company proposes to fund the project by issuing new equity. So there will not be any debt or its interest cost for project. So perpetual EBT of project will be $ 20 million & tax rate is 35%. So perpetual profit after tax will be $ 13 million [ $ 20 million * (1-tax rate)].
Value of equity of new project = perpetual profit after tax/cost of equity
= $ 13 million/ 0.15
= $ 86.67 million
Share price after announcement = Total value of equity of company including new project/ total outstanding shares
= ( $ 300 million + $ 86.67 million)/ 10 million
=$ 386.67 million/10 million
= $ 38.67 per share
No of shares to be issued = Investment of new project / share price after announcement
= $ 100 million / $38.67
=2,585,984 shares approx.
Answer b)
If investors however believe that the project cash flow is only EBIT = $10 million.
Company proposes to fund the project by issuing new equity. So there will not be any debt or its interest cost for project. So perpetual EBT of project will be $ 10 million & tax rate is 35%. So perpetual profit after tax will be $ 6.5 million [ $ 10 million * (1-tax rate)].
Value of equity of new project = perpetual profit after tax/cost of equity
= $ 6.5 million/ 0.15
= $ 43.33 million
Share price after announcement = Total value of equity of company including new project/ total outstanding shares
= ( $ 300 million + $ 43.33 million)/ 10 million
=$ 343.33 million/10 million
= $ 34.33 per share
No of shares to be issued = Investment of new project / share price after announcement
= $ 100 million / $34.33
=2,912,904 shares approx.
Answer C
Suppose after the company had issues shares as in part b, new information emerges that convinces investors that the company investors are correct. This means investors agree that value of equity of new project is $ 86.67 million.
Share price of the company = Total value of equity of company including new project/( total existing outstanding shares + New issue of shares as calculated in B above)
= ( $ 300 million + $ 86.67 million)/ (10 million + 2,912,904)
= $ 386.67 million / 12,912,904
= $ 29.94 per share
Answer D
Suppose in part a, the company instead issues permanent, risk-free debt to finance for the project. investors believe as in part b (i.e. perpetual EBIT will be $ 10 million).
Million $
Particulars
Amount
EBIT
10
Interest
5
(100 million*0.05)
EBT
5
Tax (35% of 5 million)
1.75
Profit after tax
3.25
Value of equity of new project = perpetual profit after tax/cost of equity
= $ 3.25 million/ 0.15
= $ 21.67 million
Share price after announcement = Total value of equity of company including new project/ total outstanding shares
= ( $ 300 million + $ 21.67 million)/ 10 million
=$ 321.67 million/10 million
= $ 32.17 per share
Share price after the arrival of the new information mentioned in part c.
Million $
Particulars
Amount
EBIT
20
Interest
5
(100 million*0.05)
EBT
15
Tax (35% of 15 million)
5.25
Profit after tax
9.75
Value of equity of new project = perpetual profit after tax/cost of equity
= $ 9.75 million/ 0.15
= $ 65 million
Share price after announcement = Total value of equity of company including new project/ total outstanding shares
= ( $ 300 million + $ 65 million)/ 10 million
=$ 365 million/10 million
= $ 36.50 per share
Comparing with part c, two advantages of debt financing in this case are
Million $
Particulars
Amount
EBIT
10
Interest
5
(100 million*0.05)
EBT
5
Tax (35% of 5 million)
1.75
Profit after tax
3.25
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