Question

WinSome Inc. has two million shares outstanding and its current assets generate earnings of $2M forever, including the current year. The company wants to launch a new product this year, which will cost $1M initially and generate earnings of $0.5M forever. The firm pays out all its cash, except when it needs to use funds for investment. The cost of capital is 15%.

	0	1	2	3…
Earnings from current assets	$2M	$2M	$2M	$2M…
Earnings from project	-$1M	$0.5M	$0.5M	$0.5M…
Total Payout	$1M	$2.5M	$2.5M	$2.5M…

a) What is the stock price of WinSome today (at year 0)?

b1) WinSome wants to pay a special dividend of $0.5 per share this year. It will issue new equity to fund the payout. New shareholders don’t get any dividends in year 0. How many shares will the company issue?

b2) At what price?

Answer 1

Answers:

a) $ 8.83

b1) 0.128 Million

b2) $ 7.84

Solution:

a) Let us calculate the present value of future cash flows using discount rate of 15%

In year 0, we get $1M

Present value of cash flow from year 1 is:

Present value of cash flow from year 2 is:

Present value of cash flow from year 3 is:

and so on....

This is a sum to infinity of geometric progression, with common ratio

The summation is equal to

= $ 17.67 M

So value of the company is $ 17.67 M

Value of each share will be (Market value)/(Number of shares) = ($ 17.67 M)/(2 M)

= $ 8.83

b1) It wants to issue a dividend of $0.5 per share

so it has to raise $ 0.5 X 2 M

= $ 1M

Let us assume they issued 'N' number of shares at 'P' price.

So total shares will become 2000000+N

And N X P = 1000000

The total value of the company for new share holders(excluding year 0 payout) is $ 16.67 M

So,

P X (2000,000+N) = $ 16,670,000

Solving the equations in P and N,

We get N = 0.128 Million

b2) Solving for P,

We get P = $ 7.84