Problem 1: Company ABC is all-equity financed. It has an expected cash flow of $10 million per year in perpetuity, and 10 million shares. Its average cost of capital is 10%. The company plans to open a new plant, which will cost $4 million, and generate $1 million in additional cash flow every year. This project has the same risk than the overall company.
1) Calculate the expected return on equity and the price of the stock before the new investment.
2) Assume that the plant is financed with new equity and calculate:
a. ABC's expected return on equity and weighted average cost of capital.
b. ABC's stock price.
c. The number of shares issued to finance the new investment.
3) Assume that the plant is financed with new perpetual debt at a 6% interest rate and calculate:
a. ABC's expected return on equity and weighted average cost of capital.
b. ABC's stock price after the new investment.
4) Is Modigliani-Miller satisfied?
5) Now assume that the company has a 35% tax rate and that the $10m and the $1m cash flows are net of taxes. Solve again parts (1), (2) and (3) in this new setting.
Problem 2: Firm A is considering making an offer to purchase Firm B. Firm A has 1,000,000 shares trading at $15, firm B has 250,000 shares trading at $36. Securities analysts expect the earnings and dividends of B (currently $1.80/share) to grow at a constant rate of 5% each year. Moreover, the acquisition would provide firm B with some economies of scale that would improve the growth rate to 7% per year.
1. What is the value of firm B to firm A?
2. If A offers $40 for each share of B, what would the NPV of the acquisition be?
3. If instead A were to offer 600,000 of its shares in exchange for the outstanding stocks of B, what would the NPV of the acquisition be?
4. Should the acquisition be attempted and, if so, should it be a cash or stock offer? Firm A's management thinks that 7% growth is too optimistic and that 6% is more realistic. How does this change your previous answer?