Malibu Mannequins is an all-equity firm with 40 million shares outstanding.Malibu has $20 million in cash,and expects future free cash flows of $5 million per year.The cash can be used to expand the firm's future operations,increasing future free cash flows to $8 million per year.If Malibu's cost of capital for the expansion is 5%,what will be the difference in the firm's share price compared to using the cash for a share repurchase?

Question

Quizplus · Accepted Answer

Using the cash for expansion increases the future free cash flows of the firm from $5 million to $8 million, resulting in a higher firm value. The present value of these cash flows using a 5% cost of capital is $160 million. Dividing this by the number of shares outstanding gives us a share price of $4. Therefore, the share price with expansion is $4, while the share price with a share repurchase will be $3 per share, which is the current share price. Therefore, the difference in share price would be $1 per share higher with expansion.

Malibu Mannequins Is an All-Equity Firm with 40 Million Shares