Question

2. 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.

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

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

      with the equity issuance or abandon the project?

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

      with the equity issuance or abandon the project?

Answer 1

For Scenario 1 :

Investors do not infer anything and hence the estimate of the value of company's assets = ($2m+$10m) /2 = $6 m

So, with $10m project of $1 m NPV, the value of the company = $6m + $1m = $7 million

So, Price at which shares can be issued = $7 million/ 1 million shares = $7 per share

For Scenario 2 :

Investors infer that the value of company's assets is $2 million

So, with $10m project of $1 m NPV, the value of the company = $2m + $1m = $3 million

So, Price at which shares can be issued = $3 million/ 1 million shares = $3 per share

For Scenario 3 :

Investors infer that the value of company's assets is $10 million

So, with $10m project of $1 m NPV, the value of the company = $10m + $1m = $11 million

So, Price at which shares can be issued = $11 million/ 1 million shares = $11 per share

If the managers knew the value was $2m, and that correct issue price is $3 per share

For Scenario 1 : They would prefer to issue shares as the shares can be issued at a higher price than $3 per share

For Scenario 2 : They would prefer to issue shares as the shares can be issued at same price of $3 per share

For Scenario 3 : They would prefer to issue shares as the shares can be issued at a higher price than $3 per share

If the managers knew the value was $10m, and that correct issue price is $11 per share

For Scenario 1 : They would prefer not to issue shares as the shares can be issued at a lower price than $11 per share . And they would decide to abandon the project

For Scenario 2 : They would prefer not to issue shares as the shares can be issued at a lower price than $11 per share.And they would decide to abandon the project

For Scenario 3 : They would prefer to issue shares as the shares can be issued at the same price of $11 per share