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 needs to finance the purchase of the new plane with equity, will it make sense for them to purchase the plane? Assume managers act in the interest of long-run shareholders. [Hint: If they issue equity assume that the market will eventually correctly value the old assets of the firm - that is they will figure out the stock price of the firm without the airplane should have been $100. Use as your decision criterion the choice that maximizes the firm's stock price after the market values all assets at their fair fundamental value.]

Explanation / Answer

It will make sense to purchase with equity because the NPV is positive 450000-350000= $ 100000

Also the market will eventually correctly value the assets of the firm and the share price will go up

to its correct value.

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