In addition to the fixed assets, the firm has (i) £1 million of excess cash at year 0, deposited in a non- interest-bearing bank account, and (ii) the opportunity to invest £11.5 million in year 2 in a project that subsequently yields £11.9 million in year 3. Therefore, in order to invest in the project, the firm needs to raise additional funds of £10.5 million.
Your objective is to maximize the firm’s share price in year 3.
a. Assume that you can raise £10.5 million by issuing new shares at a price of £8.11 per share before making the potential investment in year 2. If the value of the firm’s fixed assets is A = £12 million, would you issue shares and invest in the project or not? What if A = £6 million?
b. Now assume that an investment banker informs you that you could use the £1 million of excess cash to repurchase shares at a price of £11.55 per share in year 1, and then raise the full £11.5 million needed to invest in the project by issuing new shares at a price of £8 per share in year 2. If the value of the firm’s existing assets A = £12 million, which of the following alternatives would you choose: 

(i) repurchase shares in year 1 and then do nothing in year 2,

(ii) repurchase shares in year 1 and then issue new shares and invest in the project in year 2, (iii) do nothing in both years. How would your answers change if A = £6 million? What if A = £9 million?

Answer rating: 100% (QA)

SOLUTION a We can use the net present value NPV of the investment project to determine whether the firm should issue new shares and invest in the project or not The NPV of the project is calculated as ... View the full answer