question archive The current stock price of Spartan airlines is $40
The current stock price of Spartan airlines is $40
Subject:AccountingPrice:3.87 Bought7
The current stock price of Spartan airlines is $40. If Spartan issues equity, Spartan's management anticipates that the market will react negatively and that Spartan will onlyr be able to sell the new shares for $35 per share. However, Spartan airlines management knows that if they do not issue equity their stock will soon go up to its fair fundamental value of $50 per share. Management knows this because they have inside information that future earnings will be higher than the market expects. Currently Spartan has 100,000 shares outstanding. Spartan is considering investing in a new airplane that will cost them $350,000. They anticipate that the present discounted value of increased earnings from purchasing the new plane is $450,000.
(a) If Spartan had the cash available to purchase the new plane, should it make the purchase?
(b) If Spartan needs to finance the purchase of the new plane with equity, will it make sense for them to purchase the plane?
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Answer:
A
stock price increase ($51) after Investment, So plane should be purchased.
B.
Price of Stock will go below ($46.36) true value of stock that is $50. So plane should not be purchased.
Step-by-step explanation
A.
If cash is available, no need to issue New shares.
Current shares = 100000
True Expected Market price =$50
True value of firm = 100000*50= 5000000
Expected NPV from Investment = Discounted Present Value - Investment made
=450000-350000
=100000
Total Value after Investment = True Value + Expected NPV of Investment
5000000+100000
=5100000
Stock price = Total value / number of shares
5100000/100000
=$51
So stock price increase ($51) after Investment, So plane should be purchased.
B.
New shares will be issued at $35
Investment required =$350000
New shares issued = 350000/35
=10000
New number of shares = Existing shares + New shares
100000+10000
=110000
Total value after Investment (from part a)= 5100000
Stock price = Total value / number of shares
5100000/110000
=46.36363636
Price of Stock will go below ($46.36) true value of stock that is $50. So plane should not be purchased.
