Question

ABC Inc is an all equity firm. It has 3,000,000 shares outstanding. The company has $28,000,000 of excess cash. The company will generate $16,500,000 in perpetuity. The company's required rate of return is 11 percent per year compounded annually. The company is planning on invested the $28,000,000 of excess cash in a project that will increase the free cash flow by $1,600,000 in perpetuity. As a result of doing the project the company's stock price will change by how much?

Answer 1

Solution :-

Present Value of Perpetual Cash flows = $16,500,000 / 11% = $150,000,000

Excess Cash = $28,000,000

Therefore Net Firm Value = $150,000,000 + $28,000,000 = $178,000,000

Shares Outstanding = 3,000,000

Therefore Share Price = $178,000,000 / 3,000,000 = $59.33

Now If Company Invest $28,000,000

then the Value of Annual Perpetual Cah Flows = $16,500,000 + $1,600,000 = $18,100,000

Now The Present Value of Perpetual Cash Flows = $18,100,000 / 0.11 = $164,545,454.55

Therefore Net Firm Value = $164,545,454.55

Shares Outstanding = 3,000,000

Therefore Share Price = $164,545,454.55 / 3,000,000 = $54.85

Therefore As a result of doing the project the company's stock price will change by = ( $54.85 - $59.33 = - $4.48

Stock Price Decrease by $4.48

Stock Price Decrease ( % ) = $4.48 / $59.33 = - 7.56%

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