Question

A company has 1000000 shares outstanding trading at $15 a piece. Managers believe that the discount rate appropriate for the risk borne is 15% and total cash flows, expected to be $1 million next year, will rise by 5% per year indefinitely. Discuss a strategy that is beneficial to the current shareholders.

Answer 1

Step-by-step explanation:

Knowing the value of the equity and establishing the intrinsic worth of the share may help you develop a perfect strategy that will benefit the current shareholders.

Value of the equity = Cashflow÷(discount rate - growth rate)

= $1,000,000 ÷ (15%-5%)

= $1,000,000 ÷ (10%)

= $10,000,000

Intrinsic value per share = Value of the equity ÷ Shares outstanding

= $10,000,000 ÷ 1,000,000

= $10

For the share, The intrinsic value = $10

However, since the current trading share price is $15, then we can posit that the share price is over-valued.

As a result, the perfect strategy that will be beneficial to the shareholders is for the current shareholders to sell the shares (short selling at a high price and purchasing at a low price).