3. The current stock price of Alpha airlines is $80. If Alpha issues equity, Alp

Question

3. The current stock price of Alpha airlines is $80. If Alpha issues equity, Alpha’s management anticipates that the market will react negatively and that Alpha will only be able to sell the new shares for $70 per share. However, Alpha airlines management knows that if they do not issue equity their stock will soon go up to its fair fundamental value of $100 per share. Management knows this because they have inside information that future earnings will be higher than the market expects. Currently Alpha has 50,000 shares outstanding. Alpha is considering investing in a new airplane that will cost them $350,000. They anticipate that the present discounted value of increased earnings from purchasing the new plane is $450,000.

(a) If Alpha had the cash available to purchase the new plane, should it make the purchase?

(b) If Alpha needs to finance the purchase of the new plane with equity, will it make sense for them to purchase the plane? Assume managers act in the interest of long-run shareholders.

Explanation / Answer

(a) Yes, Alpha should purchase the new plane with available cash because the NPV of the project is positive (= $450,000 - $350,000 = $100,000) which indicates value addition for the existing shareholders.

(b) No, because with the issue of new shares the no. of outstanding shares would double with another new 50,000 shares (= $350,000 / $70 = 50,000). This would the reduce the earning per share of the existing shareholders and so it would be detrimental to the interest of the existing shareholders (long-run shareholders).

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