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Corporate Investment and Shareholder Wealth. Why do positive NPV investments lead to increases in share price?. FPC Example (720 notes, p. 204). Firm has no debt Existing assets generate cash flows of $9M per year forever Discount rate = 10% Firm has n shares

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Corporate Investment and Shareholder Wealth

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Corporate investment and shareholder wealth l.jpg

Corporate Investment and Shareholder Wealth


Why do positive npv investments lead to increases in share price l.jpg

Why do positive NPV investments lead to increases in share price?


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FPC Example (720 notes, p. 204)

  • Firm has no debt

  • Existing assets generate cash flows of $9M per year forever

  • Discount rate = 10%

  • Firm has n shares

    (5 mil) currently selling at P0 = $18 per share


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Share Price Effect of New Project

  • Now firm plans to invest I = $20M in new project

  • Project will generate $3M CF per year forever

  • Firm will issue n new shares at price P0* to finance project (proceeds = 20M)


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NPV and Share Price

  • Wealth of original shareholders goes up by NPV of new project


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Further Implications

  • 5 million original shares go up in value by $10M

  • Price per share goes up by $2 from $18 to $20

  • At a share price of $20, need to issue 1 million new shares to raise $20 million

  • New shareholders own 1/6 of firm, so can claim (1/6)x12 = 2M in cash flow, so earn 10% return


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Points to Emphasize

  • One-to-one correspondence between positive NPV and increase in stock price (primary justification for NPV criterion)

  • All of project’s NPV captured by original shareholders

  • Importance of efficient capital market


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What if the Market is Inefficient?

  • Suppose new shares can only be sold for $18 (= P0)?

  • Company must sell 20/18 = 1.111 million new shares (i.e. 6.111 million shares in all)

  • Eventually, company will be recognized to be worth $120 million, so share price will rise to 120/6.111 = $19.6364


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Inefficient Market and Shareholder Wealth

  • After company value is recognized and share price rises, original shareholders gain (5 M shares) x (19.6364 – 18) = 8.182

  • New shareholders gain:

    (1.111 M shares) x (19.6364 – 18) = 1.818

    They earn a return of (12/6.111)/18 = 10.91% (more than needed to attract capital)


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Inefficient Market Transfers Wealth

  • Because new shares are sold too cheaply, new shareholders gain

  • At the expense of the original shareholders


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NPV and Growth Opportunities

  • In the FPC example, where the project is to be undertaken now, in the instant before it is adopted, stock price is given by:


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Stock Price Representations

General Case Constant Growth Special Case

1. Dividend Discount Model

2. Growth Opportunities Model


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