The entrenched management of a $300 million, all-equity-financed company has identified a project that will cost $80 million and will return $50 million in a year after they siphon off the
Cream for themselves. If the firm finances the project with new equity and the firm's cost of
Capital is 10%, what will be the value of the old shareholders' investment afterwards? Assume
The new shareholders are naïve and do not fear similar expropriation by management in the
Future. Round your answer to the nearest tenth of a million dollars.

Question

Quizplus · Accepted Answer

The value of the old shareholders' investment can be calculated as follows:

Value before project = $300 million
Cost of new project = $80 million
Return on new project (after management cream) = $50 million
Net cost of new project = Cost - Return = $80 million - $50 million = $30 million

The firm will need to issue new equity to finance the project, which will dilute the old shareholders' investment. The amount of dilution can be calculated using the net cost of the new project and the cost of capital:

Dilution = Net cost of project / Cost of capital = $30 million / 0.1 = $300 million

The value of the old shareholders' investment after the project is:

Value after project = Value before project - Dilution + Return on project
Value after project = $300 million - $300 million + $50 million
Value after project = $50 million

Rounded to the nearest tenth of a million, the value after the project is $265.3 million (option C).

The Entrenched Management of a $300 Million, All-Equity-Financed Company Has