We have come to an disagreement in the group of how to solve the following assignment, the discussion is whether the answer is:

a) 1) ~2$ and 2) ~0,02$.

b ) 2) ~1$ and 2) ~0,01$.

Could anyone show me how it is done correctly, and what answer you get?

Thanks in advance!!

Assignment:
You have been asked to value a project for ABC. The project requires an investment outlay at t = 0 of $3,000,000. The project's real after-tax cash flow (i.e. measured in the price level of t = 0) is estimated to be $600,000 per year for 6 years. ABC has asked you to use the following assumptions:

* Risk-free interest rate per year: 3 percent.
* Expected risk premium (on the market portfolio) per year: 5 percent.
* Asset beta of the project: 0.8.
* Corporate tax rate: 35%.
* Inflation per year: 2 percent.
* Part of the project's investment outlay may be financed by issuing risk-free debt.
* Investment outlay is financed by ABC issuing bonds worth $1,500,000 and stocks worth
$1,500,000.
* The project's debt will be paid off over the project's 6 year life: ABC has decided on an annual
repayment of the principal of $1,500,000 / 6 = $250,000.
* ABC's current stock price (before accepting the project): $30.
* ABC's current number of stocks outstanding (before accepting the project): 50,000

1) What is the expected change in ABC's current stock price if the project is accepted?

2) Assume ABC incurs issue costs of (7 percent of $1,500,000 =) $105,000 to raise the
$1,500,000 equity for the investment outlay. What is the expected change in ABC's current
stock price if the project is accepted?

This post was edited by Petari on Jan 4 2017 06:21am

about tree fiddy

Its been a looooooong time since i've taken a finance class so this could be absolutely completely 100% wrong but this is how I would look at it just my view...The problem seems to have given you a lot of unnecessary information. Going off the 2 questions it is asking it seems you've already made the assumption that the company is going ahead with the investment, as such, calculating any form of WACC or Rd/Re is irrelevant. All they are asking you is what happens to the stock if the project goes through.

According to whats written the project will require an initial outlay of 3MM a t=0. The project will return 600k per year for 6 years in t=0 dollars (I am going to assume this means they discounted the cfs back at the rf rate and the 600k is therefore the NPV for each year?) If this is the case then the return/NPV of the project is 3.6MM. Subtracting out the intitial 3MM leaves you with 600K in profit from the proposed project.

The question says that half of the 3MM is raised by issuing 1.5MM in debt. This debt is issued at the rf rate or 3%. This means that 3% interest is due to be paid each year for 6 years. The question also states that 250k of the principal will be paid back each year over the 6 years. This means that each year the outstanding debt will decrease by 250k leading to lower interest payments each year. (i.e. year 1 = 1.25MM*.03 = 37.5k interest, year 2 = 1MM*.03 = 30K interest, year 3 = 750K*.03 = 22.5K, year 4 = 500K*.03 = 15k, year 5 = 250K*.03 = 7.5K, year 6 = 0*.03 = 0) Total interest = 112.5K if we then subtract this 112.5K from the 600K in profits we get 487.5K in profits after accounting for interest payments.

The 1.5MM raised through issuing stock does not need to have any interest repayment (The original shares outstanding = 50K at a value of $30 per share this gives us equity = $1.5MM raising an additional $1.5MM would require an issuance of an additional 50K shares bringing the total shares up to 100K this would also dilute the share price from $30 a share to $15 a share (we doubled the shares outstanding thereby halving their value).

The proposed project brings in 487.5K in profits divided by the 100K shares outstanding would lead to an overal increase of $4.875 a share if accepted. By issuing new stock however the price would have dropped from $30 to $15 but since the new project leads to a $4.875 per share increase in value the stock would only drop to $19.875 or a drop of $10.125 per share due to the dilution.

If it also cost the company $105k to issue the debt then we could also factor that into the profits. Just subtract the $105K from the $487.5K in profits and we are left with instead $382.5K in profits divide that by the 100k outstanding shares and we get $3.825 a share which would cause instead of a drop to $19.875 a drop to $18.825 or a drop of $11.175 per share or an additional drop of $1.05.