Question

A. Nahanni Treasures Corporation is an Australian company planning a new ordinary share issue of five million shares to fund a new project. The increase in shares will bring to 25 million the number of shares outstanding. Nahanni’s long-term growth rate is 6 percent, and its current required rate of return is 12.6 percent. The firm just paid a $1.00 dividend and the stock sells for $16.06 in the market. When the new equity issue was announced, the firm’s stock price dropped. Nahanni estimates that the company’s growth rate will increase to 6.5 percent with the new project, but since the project is riskier than average, the firm’s cost of capital will increase to 13.5 percent. Using the dividend constant growth model, what is the change in the equilibrium stock price and explain why this price change is likely to occur in the market – and the alternative expected patterns of the price change if the market is efficient or inefficient.

Answer 1

Initial Condition

Last Dividend = $1

Expected growth,g = 6%

Required rate of return,r = 12.6%

Expected Stock price = Dividend *(1+g)/(r-g) = 1 * 1.06/0.066 = 16.06

When new shares are issued,

Expected growth,g = 6.5%

Required rate of return,r = 13.5%

Expected Stock price = Dividend *(1+g)/(r-g) = 1 * 1.065/0.07 = 15.21

Change in equilibrium stock price is due to the difference in the risk of the project and the company.

Markets are efficiecient because the stock price already decreased as soon as the new equity issue was announced.