The entrenched management of a $200 million, all-equity-financed firm has identified a project that costs $60 million and will return $50 million in today's dollars, after the managers
Load their own pockets. If management issues more shares to finance this project, what will be
The value of the old shareholders' interest in the firm? (Assume the new shareholders are naïve
And do not fear similar expropriation in the future).

Question

Quizplus · Accepted Answer

The project is not profitable for the old shareholders, as they will be investing $60 million but only receiving $50 million in return. The only beneficiaries are the entrenched management, who will be able to further expropriate funds from the company. By issuing more shares, the old shareholders' interest in the firm will be diluted, and their value will decrease. Therefore, the best choice is B, as their interest would be worth $190 million, reflecting the decrease in value due to the new share issuance. The project costs $60 million and will return $50 million to the firm after the managers take their cut. This means that the new shareholders have invested $60 million for a return of $50 million, meaning they have lost $10 million. However, the old shareholders' interest in the firm has not changed, as they did not invest any more money. Therefore, the value of the old shareholders' interest in the firm is still $190 million ($200 million initial value minus the cost of the project of $60 million).

The Entrenched Management of a $200 Million, All-Equity-Financed Firm Has