Question

Suppose that managers of XYZ think their firm’s shares are currently overvalued and suppose that their sole objective is to maximize value for their ongoing, long-term share-holders. Assume that managers of XYZ decide to raise some capital through either (a) equity or (b) debt. Which will they prefer? Why? Under policy (a) in part (a), how would new shareholders be affected in the long-run? Discuss some empirical evidence that is consistent with your prediction (by empirical evidence, I mean some historical evidence based on data - the relevant evidence has been discussed in class and can be found in the slides). Now assume that managers of XYZ can invest the new capital in either (a) cash or (b) the typical assets of their firm. Which will they prefer? Why?

Answer 1

Solution:-

If the shares of the company are currently overvalued, it means that the the company should raise capital by issuing fresh equity shares. This is because it will result in an increase in the wealth of existing shareholders.

The increase in wealth of existing shareholders comes due to the fact that the company would receive more cash against the new shares than what they are worth and this difference between the worth of new shares and the cash received by the company would increase the wealth of the existing shareholders. Let's take an example to understand this:-

Example:-

Let's say the company currently has 1 million shares outstanding and the intrinsic value per share is $50 with the current Earning per share (EPS) being $5. So, the intrinsic value of the whole company becomes $50 million.

Now the market price of share is $100 per share, so the managers know that the shares are overvalued and hence they issue new 1 million shares at $100 per share. This will bring a $100 million cash into the company. The intrinsic worth of the company becomes $150 million (i.e. 50m + 100m) and total number of shares outstanding become 2 million. Based in this, the intrinsic value per share becomes $75.

As we can see the new shareholders paid $100 but their shares are worth just $75 while the intrinsic value of old shares increased from $50 to $75.

Hence the managers should raise capital by issuing fresh equity shares.

Impact on this policy on new shareholders in the long-run:

As we saw the new shareholders saw the intrinsic value of their shares drop to $75 per share while they paid $100. They essentially paid for an overvalued share and hence this is inevitable for them. It doesn't mean that they can't make profits in the long run which will be dependent on the long-term performance of the company, however it nonetheless holds that they got into a bad deal and it resulted into a loss of their wealth when analysed on standalone basis.

Should the new capital be invested in cash or existing assets of the business?

This totally depends on the available opportunities for expansion of the business. The shareholders have invested their money in company shares to invest in the business of the company and if the company doesn't invest funds in business assets, it nullifies the shareholders' motive of investing in business. They could also keep cash with themselves so if they invest in a company it's because they want to invest in the business.

Further, the company earns a nominal bank interest on cash. It would want to earn higher returns on investment which it earns on the remaining assets of the business. Thus, the managers should definitely invest the raised capital in the business assets if the opportunities for investment and growth are available.