The true values of assets in place of firms G and B are $700,000 and $500,000, r

Question

The true values of assets in place of firms G and B are $700,000 and $500,000, respectively. The uninformed market cannot distinguish between the two and prices them at the average of $600,000. Both firms have 20,000 shares outstanding. Both firms find out that they have access to a project that costs $200,000 and has an NPV of $30000. 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 B will accept or reject the project under these circumstances.

Explanation / Answer

For firm G the value of assets is $700,000 and the market values them at $600000 which means that the stock of firm G is undervalued. For firm B the value of assets is $500,000 and the market values them at $600000 which means that the stock of firm G is overvalued. No of shares outstanding are the same = 20,000 Project is also profitable for both the firms as the NPV is postive indicating that the project will add $30000 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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