Question

AMS Company has unexpectedly generated a​ one-time extra ​$6 million in cash flow this year. After announcing the extra cash​ flow, AMS stock price was ​$45 per share​ (it has 1 million shares​ outstanding). The managers are considering spending the ​$6 million on a project that would generate a single cash flow of ​$6.5 million in one​ year, which they would then use to repurchase shares. Assume the cost of capital for the project is 12​%. a. If they decide on the​ investment, what will happen to the price per​ share? b. If they instead use the ​$6 million to repurchase stock​ immediately, what will be the price per​ share? c. Which decision is better and​ why? a. If they decide on the​ investment, the price per share will be ​$ 44.80. ​(Round to the nearest​ cent.) b. If they instead use the ​$6 million to repurchase stock​ immediately, the price per share will be ​$ nothing

Answer 1

Given:

Current stock price = $45

Number of outstanding shares = 1 million

Extra cash flow = $6 million

Investment required for initial project = $6 million

Single cash flow = $6.5 million

Project Discount rate = 12%

If the firm decides to undertake the project the price per share will change by an amount equal to the project Net present value per share.

Project NPV = (6.5 / 1.12) – 6 = - $0.1964 M

NPV per share = Project NPV / No. of shares outstanding

                   = - $0.1964 M / 1 M = - $0.1964

Therefore, the price of stock after the project is undertaken = $45 - $0.1964

                                                                                      = $44.80

b. If they instead use the $6 million to repurchase stock immediately:

All shares are assumed to have been sold at $45 (current price of share). We all know the Total Assets has to be equal with Total Equity and Liabilities. In Assets side, the cash is going to be decreased by $6 million and In Equity and Liabilities side, the Equity is going to be decreased by $6 million. The liability will remain unchanged.

Both sides declined by same amount, the share value stays consistent at $ 45, While the number of outstanding shares is only get changed.

Therefore, the price per share will be the same value i.e. $45.

c. Undertaking the project also generates negative NPV which will bring down the share value. Repurchasing of shares has no impact on share price. The share price is going to be the same. Therefore, repurchasing share will be the better decision.