Question

Sophie Pharmaceuticals Ltd has 9.6 million ordinary shares on issue. The current market price is $12.50 per share. However, the company manager knows that the results of some recent drug tests have been remarkably encouraging, so that the ‘true’ value of the shares is $13. Unfortunately, because of confidential patent issues, Sophie Pharmaceuticals cannot yet announce these test results. In addition, Sophie Pharmaceuticals has a property investment opportunity that requires an outlay of $15 million and has a net present value of $2.5 million. At present, Sophie Pharmaceuticals has little spare cash or marketable assets, so if this investment is to be made it will need to be financed from external sources. The existence of this opportunity is not known to outsiders and is not reflected in the current share price. Should Sophie Pharmaceuticals make the new investment? If so, should the investment be made before or after the share market learns the true value of the company’s existing assets? Should the investment be financed by issuing new shares or by issuing new debt?

Answer 1

Yes the new investment should be made ,because any investment which has a positive net present value should be considered and made for positive cash flows

The investment should be made after the true value of the share price is realised in the market i.e. after the market learns about true value of company's assets. If the investment is made before market knowing true value it could act as a negative indicator for the company as people might think it is low on liquidity and not very solvent.

The investment should be financed by using debt because cost of debt is lower than cost of equity , and it also provides a tax shield towards the profit. issuing new equity could diltute its existing equity and not good for the company.