An all equity firm generates cash flows (CFFA) of $100 million every year in per
ID: 2766608 • Letter: A
Question
An all equity firm generates cash flows (CFFA) of $100 million every year in perpetuity. Based on the risk of the cash flows, a discount rate of 20% is appropriate for the firm. The firm is considering a project that will require an investment of $75 million in one year. The project will generate cash flows of $10 million in perpetuity. The project is as risky as the firm and investment in the project will be made from cash generated by the firm. Therefore, dividends in one year will be reduced. The first cash flow will be received a year after making the investment. If the firm has 10 million shares outstanding, what is the stock price before the firm makes a decision to invest in the project? What will the stock price be if the firm announces that it has decided to take the project? Is the company making the right decision?
Explanation / Answer
Answer to the Question
Calculation of Stock price before the firm makes a decision to invest in the project
Stock price $50 before taking the decision to invest in the new project.
What will the stock price be if the firm announces that it has decided to take the project
Value of share after taking the decision $47.5.
No the company is not makin the right decision because value of the firm reduced from $500 Million to $475Million.
Sl No Particulars VALUE 1 Annual Cash flow 100 2 Interest rate 20% 3 Value of Firm (3)=(1)/(2) 500 4 No of Shares 10 5 Value per share(5)=(3)/(4) 50Related Questions
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