Prada has nine million shares outstanding, generates free cash flows of $40 million each year and has a cost of capital of 10%. It also has $30 million of cash on hand. Prada wants to decide whether to repurchase shares or invest the cash in a project that generates free cash flows of $5 million each year. Should Prada invest or repurchase the shares?

Question

Quizplus · Accepted Answer

To determine which option is best, we need to compare the present value of the cash flows generated by each option.

For the share repurchase option, the cost would be: 
Number of shares repurchased = $30 million / share price 
We do not know the share price, so we cannot calculate the exact number of shares repurchased. However, we do know that the cost of capital for Prada is 10%, so we can assume that the share price would need to result in a dividend yield of less than 10% (since the cash flows from the repurchased shares will effectively act as dividends).

Assuming a share price that results in a 9% dividend yield, we get: 
Number of shares repurchased = $30 million / (9% x $40 million) = 8.33 million shares
Present value of cash flows from share repurchase = $40 million x 8.33 million shares / 1.1 = $303 million

For the investment option, the present value of cash flows would be: 
Present value of cash flows from project = $5 million / 0.1 = $50 million

Comparing the two options, we see that investing in the project generates a higher present value of cash flows, so Prada should choose to invest rather than repurchase shares.

Prada Has Nine Million Shares Outstanding, Generates Free Cash Flows