Question

4. You are the CEO of Valu-Added Industries, Inc. (VAI). Your firm has 10,000 shares of common stock outstanding, and the current price of the stock is $100 per share. There is no debt; thus, the “market value” balance sheet of VAI looks like:

VAI Market Value Balance Sheet
Assets $1,000,000 Equity $1,000,000

You then discover an opportunity to invest in a new project that produces positive cash flows with a present value of $210,000. Your total initial costs for investing and developing this project are only $110,000. You will raise the necessary capital for this investment by issuing new equity. All potential purchasers of your common stock will be fully aware of the project’s value and cost, and are willing to pay “fair value” for the new shares of VAI common.

What is the Net Present Value of this project?

How many shares of common stock must be issued (at what price) to raise the required

capital?

What is the effect of this new project on the value of the stock of the existing shareholders, if any?

Answer 1

Part A)

The net present value of the project is calculated as follows:

Net Present Value = Present Value of Cash Flows - Initial Costs

Using the information provided in the question in the above formula, we get,

Net Present Value = 210,000 - 110,000 = $100,000

Part B)

The number of shares and the price at which the shares will have to be issued is determined as below:

Share Price = (Existing Value of Equity + NPV of the New Project)/Current Number of Outstanding Shares

Here, Existing Value of Equity = $1,000,000, NPV of the New Project = $100,000 and Current Number of Outstanding Shares = 10,000

Susbstituting these values in the above formula, we get,

Share Price = (1,000,000 + 100,000)/10,000 = $110

Now, we can calculate the number of shares to be raised as below:

Number of Shares = Initial Investment Required/Share Price = 110,000/110 = 1,000 shares

The company will have to issue 1,000 shares at a price of $110 per share to raise the required capital.

Part C)

The effect of this new project on the existing stockolders is that the price of the share has increased to $110 from the previous level of $100. In other words, the new project has contributed a $10 per share increase ($110 - $100) in the price of common stock for the existing shareholders.