California Real Estate, Inc., expects to earn $71.1 million per year in perpetui

Question

California Real Estate, Inc., expects to earn $71.1 million per year in perpetuity if it does not undertake any new projects. The firm has an opportunity to invest $16.1 million today and $5.1 million in one year in real estate. The new investment will generate annual earnings of $11.1 million in perpetuity, beginning two years from today. The firm has 15.1 million shares of common stock outstanding, and the required rate of return on the stock is 12 percent. Land investments are not depreciable. Ignore taxes. a. What is the price of a share of stock if the firm does not undertake the new investment? b. What is the value of the investment? c. What is the per-share stock price if the firm undertakes the investment?

Explanation / Answer

a)

In order to calculate value per share, there is need for calculating value of the firm

Value of the firm=earnings per year/required rate of return

=$71.1millions/.12 =592.5 millions

Value per share=value of the firm/ shares outstanding

=592.5millions/15.1millions=$39.24

b)

Calculate value of the investment:

In order to calculate value of the investment, there is need for calculating the NPV of growth opportunities.

Opportunity to invest today=16.1 millions

Opportunity to invest one year later=5.1 millions

Cash inflows==11.1 millions

Rate=12%

NPV o f growth opportunities=

C0+C1/ (1+rate)+(Cash inflow/rate)/(1+rate)

(-16.1millions-5.1millions/(1+0.12))+((11.1millions/0.12)/(1+0.12))

=61.935714 millions

c)

NPV of growth opportunities per share

NPV (as calculated above)/no of shares outstanding

61.935714millions/15.1millions=4.102

Share price of the stock if the investment is undertaken

Value per share+NPVGO per share

=39.23841+4.1017029=$43.34

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