Question

AMS Company has unexpectedly generated a​ one-time extra ​$6 million in cash flow this year. After announcing the extra cash​ flow, AMS stock price was ​$45 per share​ (it has 1 million shares​ outstanding). The managers are considering spending the ​$6 million on a project that would generate a single cash flow of ​$6.5 million in one​ year, which they would then use to repurchase shares. Assume the cost of capital for the project is 15​%.

a. If they decide on the​ investment, what will happen to the price per​ share?

b. If they instead use the ​$6 million to repurchase stock​ immediately, what will be the price per​ share?

c. Which decision is better and​ why?

AMS Company has unexpectedly generated a one time extra 56 million in cash flow this year. After announcing the extra cash flow. AMS stock price was $45 per share thus 1 milion shares outstanding the managers are considering spending the 55 million on a project that would generate a single cash flow of 565 million in one year, which they would then use to repurchase shares Assume the cost of capital for the projed is 15% a. I they decide on the investment, what will happen to the price per share? b. If they instead use the $6 million to repurchase stock immediately, what will be the price per share? c. Which decision is better and why? a. If they decide on the investment, the price per share will be (Round to the nearest cent)

Answer 1

(a) Current Stock Price = $ 45, Number of Shares Outstanding = 1 million, Extra Cash = $ 6 million, Initial Project Investment Required = $ 6 million and Single Cash Flow = $ 6.5 million, Project Discount Rate = 15%

If the firm decides to undertake the project the price per share will increase/ decrease by an amount equal to the project NPV per share.

Therefore, Project NPV = [6.5/1.15] - 6 = - $ 0.3478 million

NPV per Share = - 0.3478 / 1 = - $ 0.3478

Hence, current price post undertaking project = 45 - 0.3478 = $ 44.6522 ~ $ 44.65

(b) If the extra $ 6 million in cash is used for an immediate share repurchase, all shares can be assumed to have been sold at $ 45 which is the existing stock price. This implies that in the following equation:

Assets = Equity + Liabilities , Asset side decreases by $ 6 million as cash is an asset.

Further, the number of shares outstanding go by an amount such that the total equity value also reduces by $ 6 million with Liabilities remaining constant as a share repurchase do not impact debt levels (liabilities).

Hence, if both sides of the above equation decrease in value by the same amount, the share price remains constant at $ 45 with the decrease in equity being accounted for by the lowering in the number of shares (and not price per share)

(c) As is observable, undertaking the project generates a negative NPV thereby hurting the per share value. The repurchase however, does not impact the price per share. Hence, one should favour the repurchase over the project investment.