27. Consider a company XYZ. As of today, it has 1,000,000 shares of stock outstand-
ing, trading at $50 per share and no debt. Assume that tomorrow the company de-
cides, unexpectedly, to invest in a new project, which requires an initial investment of
$10,000,000 today and is expected to produce a growing stream of cash flows, start-
ing fro m $1,200,000 in one year from now and growing at 3% per year. The cost o f
capital for the new project is estimated at 12%. These new investment plans are not
yet known. The company decides to finance the new project by issuing equity. It
would like to issue just enough shares to raise the necessary $10,00 0,000 for the initial
investment.
(a) How many shares should the company issue?
(b) What will be the share price after the new project is adopted?
(c) How would your answer change if the investment in the new project was not
unexpected, but rather was well known t o the market a mont h in advance?
28. Your rich aunt has died. Her will gives you ownership of 5,000 shares of Plum Creek
Timber Company, currently trading at $ 22 per share. But various legal complications
will delay distribution of your aunts shares to you until October 2008.
Plum Creek now pays an annual dividend of $1 .4 0 per share. Assume for simplicity
that the next dividend will be paid in September 2008, just before you will receive the
shares. (Therefore you will not receive the next dividend.) In the past Plum Creeks
dividend has increased by 3% per year. This is a reasonable long-term trend, but
security analysts are pessimistic for the immediate future. They forecast no growth in
earnings and dividends fo r the next 3 years.
Plum Creek is a relatively safe security. Investors are content with an 8% expected
rate of return.
A bank off ers to buy the shares fro m you for $18.50 per share paid immediately. (The
bank would pay $18.5 0 per share now and receive the shares next October.) Is this a
fair offer?
29. Chucky Cheese has a cost of capital of 9% per year. Its expected EPS next year is
$5.00. The firm plans to plow back 4 0% of its earnings fo r new investments in the
following years. The ROE on the new investment s is 12%.
(a) Calculate the share price and the P/E ratio of this firm.
(b) If the plowback ratio increases, will the P/E ratio increase, decrease or remain
unaffected? State any assumptions you make and give a brief justification.
(c) Given your answer t o b), what will be your advice to this firm on its dividend
policy?
30. iDoc, a health service company, is expected to generate $1 in earnings per share next
year a nd in the years to follow, from its existing assets. It plans to announce a new
program to expand its business. This new progra m will increase its plow back ratio
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