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Corporate Investment and Shareholder Wealth

Corporate Investment and Shareholder Wealth. Why do positive NPV investments lead to increases in share price?. Stock Price and NPV: A Simplified Example. Firm has no debt Existing assets generate earnings, E (=EPS*n) of $9M per year forever Discount rate = 10% Firm has n shares

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Corporate Investment and Shareholder Wealth

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  1. Corporate Investment and Shareholder Wealth

  2. Why do positive NPV investments lead to increases in share price?

  3. Stock Price and NPV: A Simplified Example • Firm has no debt • Existing assets generate earnings, E (=EPS*n) of $9M per year forever • Discount rate = 10% • Firm has n shares (5 mil) currently selling at P0 = $18 per share

  4. Share Price Effect of New Project • Now firm plans to invest I = $20M in new project • Project will generate $3M in new earnings per year forever • Firm will issue n new shares at price P0* to finance project (proceeds = 20M)

  5. NPV and Share Price • Wealth of original shareholders goes up by NPV of new project

  6. The NPVGO Model The example is consistent with text equation (6.10), where NPVGO = NPV per share of new project

  7. Further Implications • 5 million original shares go up in value by $10M • Price per share goes up by $2 from $18 to $20 • At a share price of $20, need to issue 1 million new shares to raise $20 million • New shareholders own 1/6 of firm, so can claim (1/6)x12 = 2M in cash flow, so earn 10% return

  8. Points to Emphasize • One-to-one correspondence between positive NPV and increase in stock price (primary justification for NPV criterion) • All of project’s NPV captured by original shareholders • Importance of efficient capital market

  9. NPVGO Model Stated More Generally Stock price = present value of the earnings stream from existing assets plus the present value of the NPVs per share of all current and future new projects

  10. Example: Firm with One Future Investment Opportunity

  11. Constant Growth Special Case of the NPVGO Model If company always invests the fraction b of each year’s earnings in projects that earn a constant, perpetual rate of return ROE:

  12. Stock Price Representations General CaseConstant Growth Special Case 1. Dividend Discount Model 2. NPVGO Model

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