Question
Olympus Corporation is currently selling at $50 a share and has $1 million shares outstanding. The $50 share price reflects the values of two components
Olympus Corporation is currently selling at $50 a share and has $1 million shares outstanding. The $50 share price reflects the values of two components of firm value (as we discussed in class): (1) Value of assets in place, currently valued by the market at $40 million; and (2) NPV of a new project available to the firm, valued at $10 million (PV of future cash flows from the project if it is implemented = $30 million, Investment required to implement, $20 million). Firm management believes that, while the NPV of the firms new project is accurately reflected in the market price, the firms existing assets in place are undervalued by the market, since they are aware that the firm has discovered a vast amount of oil, worth $50 million, on its property. However, they are unable to credibly convey this information to the market, so that they believe that the firms shares will be undervalued for some time. (i) Assume first that the only way the firm can raise the required capital of $20 million to implement the new project is by selling equity. If the firm management wants to maximize the long-term (intrinsic) value of the firm, should they go ahead and sell equity and implement the project? What will be the intrinsic value of the firms shares if (a) they implement the project and (b) they abandon the project? (ii) Now assume that the firm can raise the required capital by selling risk-less debt. What will be the intrinsic value of the firms share if (1) they implement the project and (2) they abandon the project?
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