Firm A is all equity with 100M shares outstanding. The firm has $150M in cash an

Question

Firm A is all equity with 100M shares outstanding. The firm has $150M in cash and expects future free cash flows of $65M/year. The management plans to use the cash available to expand the firm’s operations. The expansion will increase future free cash flows by 12%. Assume that the appropriate annual discount rate for the firm is 10%. 1. Compute the current share price of Firm A. 2. Compute the share price of Firm A if the company decides to use the cash available for a share repurchase at no premium. Show your answer. 3. Compute the share price of Firm A if the company decides to expand its operations. 4. Comment on the results obtained in parts (2) and (3). 5. Firm A believes that its shares are underpriced and that the true value is $10. The management expects that new information will come out soon and investors will revise their opinions and agree on a $10 share value for Firm A. If Firm A plans to use the $150M cash for a share repurchase, should it wait until the new information comes out or not? Show your answer.

Explanation / Answer

share price= Pv of future cash flows/no of shares

PV of future cash flows=65/discoutn rate

PV of future cash flows=65mn/.1=$650 mn

Share price=650/100=$6.5

b)

No of shares= 100mn+(150m/6.5)=123,076,923 shares

Share price=650mn/123,076,923=$5.28

c)

PV of future cash flows=cash flow at Year 1*(1+g)/(g-k)

PV of future cash flows=65*(1+12%)/(12%-10%)=$3640 mn

Share price=3640/100=$36.4

4)Expansion is better than repurchase as it increases the market value of the firm

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