A firm expects to earn $1 million per year in perpetuity if no new investment is

Question

A firm expects to earn $1 million per year in perpetuity if no new investment is made. The firm has 100,000 shares outstanding. One year from today, the firm can spend $1m for a marketing campaign. This new campaign will increase earnings the following year and every year thereafter by $210,000. Assume the cost of capital, r, is 10%. a. (5 points) What is the current stock price of the firm (i.e. w/o the new investment)? b. (10 points) What is the new stock price if this one-time investment is made? c. (5 points) What percent of the new stock price is due to the PVGO?

Explanation / Answer

a. Value of the firm = $1 million/10% = 10 million current stock price of the firm =10,000,000/100000= $100 b. Next year Value of the firm = 1210000/10% - 1,000,000= $11,100,000 stock price = $11,100,000/100000 =$111 c percent of the new stock price is due to the PVGO = 111-100/100 =11.00%

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