The current stock price of Falcon airlines is $80. If Falcon issues equity, Falc

Question

The current stock price of Falcon airlines is $80. If Falcon issues equity, Falcon's management anticipates that the market will react negatively and that Falcon will only be able to sell the new shares for $70 per share. However, Falcon airlines management knows that if they do not issue equity their stock will soon go up to its fair fundamental value of $100 per share. Management knows this because they have inside information that future earnings will be higher than the market expects. Currently Falcon has 50,000 shares outstanding. Falcon is considering investing in a new airplane that will cost them $350,000. They anticipate that the present discounted value of increased earnings from purchasing the new plane is $450,000. (a) If Falcon had the cash available to purchase the new plane, should it make the purchase?

Explanation / Answer

IF FALCON AIRLINES USES CASH TO PURCHASE THE NEW PLANE

THE NPV OF INVESTMENT IN PLANE = 450000 - 350000 =100000

SO PRICE OF SHARE WILL GO UP BY 100000/50000 = $20 PER SHARE

SO AFTER ANNOUNCEMENT, THE PRICE OF SHARE WILL BE $100

SO IT IS ADVANTAGEOUS TO MAKE PURCHASE

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