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 flow of $5 million each year. Should Prada invest or repurchase the shares?
A)repurchase
B)indifferent between options
C)invest
D)cannot say for sure

Question

Quizplus · Accepted Answer

To determine the best choice, we need to compare the two options in terms of their impact on the value of the company.

If Prada repurchases shares, the number of outstanding shares will decrease, which will increase the value of each remaining share. This is known as the share price effect. However, it will not generate any additional cash flows for the company.

On the other hand, if Prada invests in the project, it will generate additional free cash flows of $5 million each year. To determine the impact on the value of the company, we can use the formula for the present value of a perpetuity:

PV = Cash Flow / Cost of Capital

PV = $5 million / 0.1 = $50 million

Therefore, investing in the project will increase the value of the company by $50 million.

Adding the cash on hand, the total available funds are $80 million ($30 million cash + $40 million free cash flow + $10 million repurchase financing). If the full $80 million is used to invest in the project, the company's value will increase by $80 million * 0.1 = $8 million.

In comparison, if the entire $80 million is used to repurchase shares, the company's value will increase by $8 million, but the number of outstanding shares will decrease, so the share price effect will also occur.

Since investing in the project generates a higher increase in the value of the company, the best choice is to invest in the project.

Prada Has Nine Million Shares Outstanding, Generates Free Cash Flows