The true values of assets in place of firms G and B are $200,000 and 150,000, re
ID: 2697262 • Letter: T
Question
The true values of assets in place of firms G and B are $200,000 and 150,000, respectively. The uninformed market cannot distinguish between the two and prices them at the average of $175,000. Both firms have 10,000 shares outstanding. Both firms find out that they have access to a project that costs $50,000 and has an NPV of $3000. The market knows the correct cost and NPV of the project for both firms. Assume that the firms must finance the project by issuing new equity. Determine whether G and/or B will accept the project under these circumstances.
Explanation / Answer
For firm G the value of assets is $200,000 and the market values them at $175000 which means that the stock of firm G is undervalued.
For firm B the value of assets is $150,000 and the market values them at $175000 which means that the stock of firm G is overvalued.
No of shares outstanding are the same = 10,000
Project is also profitable for both the firms as the NPV is postive indicating that the project will add $3000 to the firm. But they have to issue a fresh equity to finance it
Now if the Firm B which is already overvalued issues a fresh equity a market correction will take place and the price of its stock will fall and it cannot enjoy the benefits of the uninformed market
On the other hand if the Firm G which is undervalued, issues a fresh equity a market correction will take place and the price of its stock will rise.
So firm G is likely to accept the project under these circumstances.
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