Question

Company X has an investment project requiring a $10m investment today and that has a

$1m net present value. The company has 1 million shares, no internal funds and, given the

nature of its business, cannot get debt financing. Hence it must raise funds by issuing equity

or abandon the project. While the market knows all about the investment project, it does

not know whether the value of the company’s existing assets (i.e., excluding the new

project) is $10m or $2m and regards both values as equally likely. Management knows the

assets’ value and investors are aware of that. Therefore, management must consider

investors’ (and hence the stock price’s) reaction to the announcement of an equity issue. A

priori, three scenarios are possible:

• Scenario 1: Investors would infer nothing about the assets’ value.

• Scenario 2: Investors would infer the assets’ value is $2m.

• Scenario 3: Investors would infer the assets’ value is $10m.

a. For each scenario, at what price would the company be able to issue shares?

b. For each scenario, if managers knew the value was $2m, would they go ahead

with the equity issuance or abandon the project?

c. For each scenario, given managers know the value is $10m, would they proceed

with the equity issuance or abandon the project?

d. Show that only one of the three scenarios is possible if investors react rationally.

e. In that scenario, what does the company do? Explain briefly

f. Consider the same questions as above but assuming now that the project’s NPV is $5m, not

$1m. Is the outcome (i.e., the answer to question f) different or the same? Explain briefly.

Answer 1

Solution:

In the given question we have asked to justify the management proposal on the various scenario, whether it would be acceptable by the investors or not before proceeding to justification, let’s first understand what kind of proposal management is considering.

Management wants to invest into a project whose investment requirement is $10m and NPV is $1m, great it is very simple now, because we know any project who has having positive NPV must be selected but wait did management is worried about it acceptance or rejection or he asked for something else, let’s find out

Question has mentioned that the market know about such investment project and also mentioned that management will not get debt funding for this project and advise us for equity funding, now it further says that management assets value either will be $2m or $10m, that is known to management and Investors both.

We have asked to find out the reaction of investors if following situation prevail regarding assets of the company

Scenario 1: Investors would infer nothing about the assets’ value.

Scenario 2: Investors would infer the assets’ value is $2m.

Scenario 3: Investors would infer the assets’ value is $10m.

Let’s discuss all scenario one by one

First Scenario, if investor does not aware about the value of assets that management will able to issue the share with the desired value because in this particular situation management will show the future prospects of the project and will able to convince investors to subscribe shares because investors will look for the profit, which is quite decent i.e. 10% but wait, is that project really good as question has mentioned that debt funding will not be available for this project and market knew about this investment proposal, it means investors also knew about the investment proposal and when some project is not good for debt funding it means it involves lots of risk and wherever higher risk comes, people comes conservative before investing and here investors will hesitate to subscribe the share.

Investors reaction would be negative regarding the proposal.

Second Scenario, here question has given that assets value of the company will be $2m and Investors knew this valuation also, so we will take the reference of our above discussion and again stated that as the investment proposal required $10m and it has having higher risk then still investors will not be much interested to invest in the project because they are only getting 20% leverage from the company assets, the conclusion remain the negative, investors will not ready to subscribe the share.

Third Scenario, now question has mentioned that value of company assets is $10m and Investor knew that the value of company assets is $10m then we may refer our above discussion of scenario one and two, here investors can subscribe the share because now they are backed by 100% leverage from the company assets and they will subscribe the share.

Now we know at which scenario, investors will invest or not, now we can answer the questions

Part (a)

On 1^st Scenario company will not able to issue share as investor does not know the value of share and they may be misled with the information and explanation given by the management because being a conservative investor they would like to know whether company has sufficient leverage to cover up the risk associated in project.

On 2^nd Scenario Company will able to issue share @$2 because company can only able to provide 20% leverage to investor.

On 3^rd scenario company will able to issue the share @$10 because in this scenario Investor feels 100% comfort because they assuming that company assets are valued at $10m.

Part (b)

If manager knew the value of assets is only $2m and project is risky than in such a case, they should not go with the proposal in all scenario

Part(c)

If manager knew that the value of assets is $10m then he need to show the supporting evidence to investor and try to convince them to subscribe the equity share @$10 each and go ahead with the proposal in all scenario.

Part (d)

Only when assets of the company will of $10m than and only investor will react rationally because in such case they are backed with 100% security of the company, even if investment proposal will not work out.

Part (e)

In first 2 scenario company should not go with the investment proposal as risk associated with the project is high and they do not have sufficient assets to backed their losses or to convince investor, hence only viable option is scenario 3 where investor know value of asset is $10m

Part (f)

If the NPA of the project is $5m instead of $1 than outcome may be different because we know investment proposal involve risk but now risk is coming with reward, hence in such a scenario some investor may find investment proposal lucrative and wanted to invest their money. As is the basis principle of investment higher risk bring higher rewards and investor also look for such opportunity where they can earn more instead of getting regular return, so in such case outcome will be different and in all the 3 scenario company will able to get investment from the investor for their proposal