NewEra Ltd is a firm in the auto sector with $750 million of equity and $500 million of debt in its capital structure (market values). It has 60 million shares outstanding with a 15% unlevered cost of capital and 4% risk free interest rate on its debt. The corporate tax rate is 30%. The firm is planning to come up with a new model that is expected to have an initial investment of $300 million with project having the same business risk as that of firm's existing assets. The new investment is expected to generate annual EBIT of $65 million which is expected to grow at 1% per annum until perpetuity.
a. The firm initially proposes to fund the new project by issuing equity. If investors were not expecting this investment, and if they share the firm's view of the project's profitability, what will the share price be once the firm announces the project plan?
b. Suppose investors think that the EBIT from the firm's new project will be only $45 million per year without any growth (i.e. $45 million every year to perpetuity). What will the share price be in this case? How many shares will the firm need to issue?
c. Suppose the firm issues equity as in part (b). Shortly after the issue, new information emerges that convinces investors that management was, in fact, correct regarding the cash flows from the new project. What will the share price be now? Why does it differ from that found in part (a)? How much will the old and new shareholders gain after the new information arrives?
d. Suppose the firm instead finances the expansion with a $300 million issue of permanent risk-free debt. If the firm undertakes the expansion using debt, what is its new share price once the new information comes out?
