Prada has 10 million shares outstanding, generates free cash flows of $60 million each year and has a cost of capital of 10%. It also has $40 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 $2 million each year. Should Prada invest or repurchase the shares?

Question

Quizplus · Accepted Answer

To decide between repurchasing shares or investing in a project, we compare the value created by each option. The value of the project can be calculated using the formula for the present value of a perpetuity: Value = Cash Flow / Cost of Capital = $2 million / 0.10 = $20 million. The cash on hand is $40 million. If Prada repurchases shares, it can use the entire $40 million, which is double the value created by the project. Therefore, repurchasing shares is the better option, as it utilizes the cash more effectively compared to the value created by the project.

Prada Has 10 Million Shares Outstanding, Generates Free Cash Flows