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Star Corp has 5 million shares outstanding and no growth opportunities. It just paid a dividend...

Star Corp has 5 million shares outstanding and no growth opportunities. It just paid a dividend of $6 per share and has a market value of $62.5 million.

a. What is the discount rate on Star’s stock?

b. The firm has an opportunity to invest in a new project. The project requires an additional investment of $1.2 million today and will generate additional earnings in the next 10 years. The first earnings amount of $0.3 million will begin one year from now and grow at 4% each year thereafter (until year 10). Assuming no taxes, calculate the NPV of the new project.

c. What will the stock price be if the firm undertakes the new project?

Solutions

Expert Solution

Question a:

D = Dividend = $6

P0 = Current Share Price = $62.5 million / 5 million = $12.5

Discount rate on Star's stock = D / P0

= $6 / $12.5

= 0.48

= 48%

Question b:

Initial Investment = $1.2 million

P = First earnings = $0.3 million

g = growth rate = 4%

r = discount rate = 48%

Present Value of earnings = [P / (r-g)] * [1 - [(1+g)/(1+r)]^n]

= [$0.3 million / (48%-4%)] * [1 - [(1+4%)/(1+48%)]^10]

= 0.681818182 million * 0.97042691

= $0.661801835 million

= $0.66 million

NPV of new project = Present value of earnings - Initial investment

= $0.66 million - $1.2 million

= -$0.54 million

Therefore, NPV of the Project is -$0.54 million

Question c:

New market value = Market value + NPV of the Project

= $62.5 million - $0.54 million

= $61.96 million

Stock price if firm undertakes the project = New market value after the project / Number of shares

= $61.96 million / 5 million

= $12.392

Therefore, stock price if firm undertakes the project is $12.39

jeff jeffy answered 1 year ago

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