Harris Corporation is an all-equity firm with 100 million shares outstanding. Harris has $250 million in cash...

Harris Corporation is an all-equity firm with 100 million shares outstanding. Harris has $250 million in cash and expects future free cash flows of $85 million per year. Management plans to use the cash to expand the firm’s operations, which will in turn increase future free cash flows by 15%. If the cost of capital of Harris’ investments is 12%, how would a decision to use the cash for a share repurchase rather than the expansion change the share price?

Expert Solution

– If Harris corporation uses the cash to expand, its future free cash flows will increase by 15% i.e $97.75 million per year ($85 million * 1.15) . Using the perpetuity formula, its market value will be $97.75 million ÷ 0.12 = $814.58 million, or $814.58 million ÷ 100 million shares = $8.146 per share.
	– If Harris corporation does not expand, the value of its future free cash flows will be $85 million ÷ 0.12 = $708.33 million. Adding the cash, Harris corporation’s market value is $958.33 million, or $958.33 million ÷ 100 million shares = $9.583 per share.
		– If Harris corporation repurchases shares, there will be no change to the share price: It will repurchase $250 million ÷ $9.583 per share = 26.09 million shares, so it will have assets worth $ 708.33 million with 73.91 million shares outstanding (100 million – 26.09 million), for a share price of $9.583 per share ($708.33 billion ÷ 73.91 million share)
			– Thus, repurchase is better than expansion since there is no change in share price and increase in value of assets

jeff jeffy answered 1 year ago

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