In an IPO, NeoDiagnostic sold 10,000 shares for $35 each, but all the money exce

Question

In an IPO, NeoDiagnostic sold 10,000 shares for $35 each, but all the money except for $100,000 was subsequently spent on an R&D; project. NeoDiagnostic Inc therefore currently has $100,000 cash on hand and, so far as investors know, no other assets. NeoDiagnostic announces that the R&D; project yielded a newly obtained patent that the firm wants to exploit in a new manufacturing operation. NeoDiagnostic has determined that it will need to invest $525,000 to move into the manufacturing phase for its new product. It intends to raise some of the new funds it will need by borrowing $200,000 at an interest rate of 6% per annum. The debt will be retired in full at the conclusion of the project in 11 years from now. Assume that the corporate tax effect of debt approximates the overall effect of debt on firm market value. Remaining funds needed for the investment will be raised through a new equity issue. NeoDiagnostic assumes that the new project will not alter investor's perceptions of the fundamental risks for the company's business. The CAPM beta coefficient for NeoDiagnostic's (currently unlevered) equity is 2.19, while the riskless interest rate is 3.25% and the market risk premium is 5.25%. The corporate tax rate is 34%. The project is expected to return before-tax cash flows of $94,730 at the end of the first year, growing at 7.5% annually for each of the following 10 years, at which point the project ends. The $525,000 investment can be depreciated on a straight-line basis over 10 years, with the first allowance applicable one year from today. NeoDiagnostic will use the riskless interest rate to discount the associated depreciation tax shield. Use the APV approach to levered valuation to calculate the NPV of this investment project. What should happen to the price of the company's stock upon announcement of the investment project and associated financing mechanism? How many shares would have to be floated to finance the investment? Write down the market value balance sheet immediately before the project and associated financing mechanism is announced. Write down the market value balance sheet immediately after the project is announced but before the debt and new equity have been sold. Write down the market value balance sheet after the debt and new equity have been sold but before the investment has occurred. Finally, write down the market value balance sheet immediately after the investment has been made before any other revenue or expenses have accrued.

Explanation / Answer

YEARS CASH INFLOW RETURN NET OF TAX TOTAL INTEREST EXPENSE NET OF TAX NET INFLOW PV FACTOR @ 7.63 % NPV 1 94730 6295 101025 7920 93105 0.9291 86505 2 101835 6295 108130 7920 100210 0.8632 86505 3 109472 6295 115767 7920 107847 0.8020 86499 4 117683 6295 123978 7920 116058 0.7452 86485 5 126509 6295 132804 7920 124884 0.6924 86465 6 135997 6295 142292 7920 134372 0.6433 86439 7 146197 6295 152492 7920 144572 0.5977 86407 8 157162 6295 163457 7920 155537 0.5553 86371 9 168949 6295 175244 7920 167324 0.5159 86329 10 181620 6295 187915 7920 179995 0.4794 86283 NPV 864288

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