Question

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

The current price is $16.06

After new issue of shares, the company expects that growth rate will rise to 6.5% but due to riskiness of project, ke will be 13,5%

so revised market price = P₀ = D₁/(Ke - g)

where D1= 1(1+0.065) = 1.065 , Ke =0.135

Revised P₀ = 1.065/ (0.135-0.065) = $15.21

so change in price = $16.06 = $15.21 = 0.085 (reduction in price)

The above change is due to statement by the company that project will be riskier. The shareholder feels that proejct is riskier and so sell of equity shares by shareholders in market will reduce the price.

when the markets are efficient, the above price will be correct.

The riskiness will always reduces the price of stocks.

If markets are not efficient, we may see price remains stable as past data are good but may decline too fast in overacting the management statment but again after sometime come to equilibrium price of $15.21