Question

Note: If not otherwise stated, assume that:

• Firms make annual dividend payments

• Stock prices are the present value of all future dividends and don’t include dividends that were just paid.

Investors estimate that Healthy Hub Food’s (HHF) existing business generates $2.5 million in annual earnings every year for the foreseeable future (i.e., forever). HHF has 2 million shares outstanding and its required rate of return is 15% (EAR).

a) What would be the value of a single HHF share if the company will not make any new investments and will pay out all its future earnings in dividends (next dividend is paid in one year from today)?

Select one:

$1.50

$2.50

$12.50

$8.33

$25.00

$10.83

$9.58

$16.67

Now suppose HHF has the following investment opportunities (note, the management of HHF will implement all positive NPV projects and will reject any negative NPV projects):

Projects	Investment at t=2 (in two years)	Earnings generated per year
US Expansion	$2 million	$300,000 (forever, from t = 3 to ∞)
Asian Expansion	$7 million	$1 million (for 20 years, from t = 3 to 22)

b) Based on what you know about the above investment opportunities, how much would you be willing to pay for a share of HHF today?

Select one:

$8.33

$0.00

-$0.56

$7.77

$7.59

$25.00

$9.58

$2.50

NOTE: Please show all the work, without using excel, unless necessary. (step by step with equations) Thanks!

Answer 1

a) The stock price is PV of all future cash flows. So, we know that the Cash flows are going to be 2.5 Mil annually, starting from next year, and this has to be discounted to PV

Stock PV= 2.5/1.15+ 2.5/1.15² + ....

By putting the GM mean formule and solving, we get 8.33$ per share.

b) we know that the Firm will invest in all non negative NPV projects. So we will try to calculate the NPV:

US Expansion: Initial Investment = -2000000

Cash Flows:

T1 = 300,000
T2 = 300,000
T3 = 300,000

PV= 300,000/1.15+300000/1.15^2 + 300000/1.15^3 + .....

We see that PV=2M Thus NPV=0. Since NPV=0,we are indifferent to the investment. Thus we can ignore,since it will make no difference to the Share Price.

Asian Expansion

We will now calculate NPV for This project:

-7000000 + 1000000/1.15+1000000/1.15^2+...+1000000/1.15^20 = -$740,668.53

Since NPV is negative, we will not invest.

This Stock value will be same in second case also.