Question

Financing choice in perfect markets (assume no taxes)

PAM is a small company with the following assets:

• Existing assets with current book value of $6 million. These assets will generate cash flows of either $8 million or $8.8 million next year, depending on whether the economy is in a recession or a boom.
• A new project idea which requires an investment of $2 million and will generate total cash flows (including any salvage or terminal value) next year of either $4 million (recession) or $8 million (boom). The firm has not yet raised the cash to make this investment, but the market is aware of the investment opportunity.

PAM will cease to exist after the cash flows are realized and distributed to investors.

Both states of the economy are equally likely. For these types of risky investments the market requires a 20% expected return on assets.

The firm has no debt and there are currently 100,000 shares (0.1 million) outstanding.

Assume perfect markets (i.e., there are no taxes or transaction costs, no asymmetric information or incentive problems).

1. Fill in the book value and market value balance sheets for PAM right now (before any financing is raised for the new project):

Book Values:                                                              Market Values:

Assets:	D: E:		Assets:	D: E:

In parts 2) through 6), assume the firm finances the new project by issuing equity.

2. If PAM issues new equity to fund the project, fill in the book value and market value balance sheets for PAM immediately after the financing is raised:

Book Values:                                                              Market Values:

Assets:	D: E:		Assets:	D: E:

3. What is the current price per share?
4. How many new equity shares does the firm need to issue?
5. When the firm is liquidated next year, what are the expected cash flows per share to equity holders?
6. What is the (%) expected return to equity holders?

Please provide work and explanations. Thanks!

Answer 1

From the information present in the question we know that -

1) Presently the firm has assets worth $6 million.

2) Expected future cash flow is $8 million (recession) and $8.8 million (boom).

3) Expected return required by investors is 20% (this is our discout factor).

4) New project would cost $2 million (would require fresh issue of shares) and expected return after 1 year would be $4 million (recession) and $8 million (boom).

Book Value and Market Value based on current setup -

	Book Value	Market Value
Debt	-	-
Equity	$6.00 M	$7.00 M

Market Value of Equity = [($8 million + $8.8 million)*0.5] / 1.20.

We are assuming 50% probability of a recession and boom. Hence, we are adding both the future expected cash flows and bringing them to their present value (dividing by 1 + 20% expected return).

Current price per share = $7 million / 100,000 = $70 per share

Number of equity shares required to be issued = $2 million / market price per share = $2 million / $70 = 2,857.143

Expected cash flow if the company is liquidated -

1) $8.4 million (based on current assets)

2) $6.0 million from new project ($4 million and $8 million with a 50% probability for each)

Expected cash flow after 1 year = $8.4 million + $6 million = $14.4 million

Return for equity shareholders = [(PV of Expected Cashflow / Total No of Shares) - MV of 1 share] / MV of 1 share

={[($14.4 million / 1.2) / (100,000 + 2,857.143)] - $70} / $70

=($116.67- $70) / $70 = 66.67%