Company X has an investment project requiring a $10m investment today and that has a $1m net present value. The company has 1 million shares, no internal funds and, given the nature of its business, cannot get debt financing. Hence it must raise funds by issuing equity or abandon the project. While the market knows all about the investment project, it does not know whether the value of the company’s existing assets (i.e., excluding the new project) is $10m or $2m and regards both values as equally likely. Management knows the assets’ value and investors are aware of that. Therefore, management must consider investors’ (and hence the stock price’s) reaction to the announcement of an equity issue. A priori, three scenarios are possible:

Scenario 1: Investors would infer nothing about the assets’ value.

Scenario 2: Investors would infer the assets’ value is $2m.

Scenario 3: Investors would infer the assets’ value is $10m.

For each scenario, at what price would the company be able to issue shares?

For each scenario, if managers knew the value was $2m, would they go ahead

with the equity issuance or abandon the project?

For each scenario, given managers know the value is $10m, would they proceed

with the equity issuance or abandon the project?

Answer rating: 100% (QA)

For Scenario 1 Investors do not infer anything and hence the estimate of the value of the companys a... View the full answer