Question

MBM Industries is an all-equity firm with 50 million shares outstanding. MBM has £200 million in cash and expects future free cash flows of £75 million per year. Management plans to use the cash to expand the firm's operations, which in turn will increase future free cash flows by 12%. MBM's cost of capital is 10%; assume that capital markets are perfect.
i. What is the value of MBM if it uses the £200 million to expand?
ii. What is the value of MBM if it does not use the £200 million to expand and holds the cash instead?
iii. What is the NPV of MBM’s expansion project?
iv. A member of MBM's board of directors suggests that MBM's stock price would be higher if they used the £200 million to repurchase shares instead of funding the expansion. If you were advising the board, what course of action would you recommend: expansion or repurchase? Which provides the higher stock price?

Please, type it, as it is hard to understand handwriting.

Answer 1

i. What is the value of MBM if it uses the £200 million to expand?

Value of MBM if it uses 200 million = Free Cash Flow/ discount rate

Free Cash flow = 75 * 1.12 = 85 million

r = 10%

= FCF/r = 84/0.10 = 840 million

ii. What is the value of MBM if it does not use the £200 million to expand and holds the cash instead?

If it doesnt use 200 million to expand and hold cash instead.

Value of MBM = = FCF/r = 75/0.10 + 200 million= 950 million

iii. What is the NPV of MBM’s expansion project?

NPV of MBM's expansion Project = 840 million -  950 million = -110 million

iv. A member of MBM's board of directors suggests that MBM's stock price would be higher if they used the £200 million to repurchase shares instead of funding the expansion. If you were advising the board, what course of action would you recommend: expansion or repurchase? Which provides the higher stock price?

from the above calculations, it is clear that expansion couldnt prove to add value to the organisation, rather it reduces the value of the firm. hence it is not recommended to go for expansion. Still repurchase could be a better option, because it will reduce the outstanding shares in the market, by the equivalent amount as it will reduce the value of the firm, its net effect will be zero.