Suppose that a company must examine an investment today (1st January) costs 100

Question

Suppose that a company must examine an investment today (1st January) costs 100 000 SEK. This investment would provide SEK 30 000 in cash to the company at the end of each year for the 5 coming years. The company's market value is SEK 5 000 000. The Company's stock is valued at SEK 250. Ignore taxes.

a) Calculate and answer whether the company should implement the investment on the company's cost of capital is 0?

b) Calculate and answer whether the company should implement the investment on the company's cost of capital is infinitely high?

c) Adopt a discount rate of 10% and cash flow under conditions decreases by 3% annually forever. Calculate and answer whether the company will implement the investment.

d) If the company has a discount rate of 10%, what will be the company's stock price if the implementation given basic conditions above?

e) Assume that a share pays 8 crowns in dividends now and is expected to increase by 6% continuously. What is the maximum price you are willing to give for this share if you have a required return of 21%?

Explanation / Answer

Let cost of capital = r

(a) r = 0

NPV = - 100,000 + 5 x 30,000 = 50,000

Since NPV > 0, investment is advisable.

(b) r = infinite

In this case, discounted cash inflows are all 0, leaving NPV = - 100,000 < 0, so investment should not be undertaken.

(c) r = 10%, reduction in cash flow = 3%. So,

Effective discount factor = 0.97 / 1.1 = 0.882 = 8.82%

NPV = - 100,000 + 30,000 x Present value interest factor of annuty (8.82%, 5 years)

= - 100,000 + 30,000 x 3.9079 (From PVIFA table)

= -100,000 + 117,237

= 17,237

Since NPV > 0, investment is advised.

(d) Question not understood. Stock price cannot be computed from NPV of any potential investment, but is derived from future cash flows (dividends) discounted to present value. No dividend information is given in any of the parts from (a) to (d).

(e)

Stock price = (Current dividend x Growth rate) / (Required return - growth rate)

= 8 crowns x 1.06 / (0.21 - 0.06) = 8.48 crowns / 0.15 = 56.53 crowns.

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.