Question

6. Harris Corporation is an all-equity firm with 100 million shares outstanding. Harris has $250 million in cash and expects future free cash flows of $85 million per year. Management plans to use the cash to expand the firm’s operations, which will in turn increase future free cash flows by 15%. If the cost of capital of Harris’ investments is 12%, how would a decision to use the cash for a share repurchase rather than the expansion change the share price?

Answer 1

Answer:

Using the discount cash flow model to value the company, we can say that the company is worth $85 million / 12% = $708.33 million

Each stock should be worth approximately $708.33 million / 100 million = $7.0833 per stock

If the company uses the cash to finance new projects, then future cash flows should be approximately $97.75 million, and the company's value = $97.75 million / 12% = $814.583 million. This represents a 15% increase in value. The stock price should also increase by 15% to $8.1458 per stock.

If the company instead decides to repurchase stocks using all the cash, then it could repurchase 35.29 million stocks. Since we are assuming that the company's future cash flows wouldn't be affected by this decision, then the company's total value will still be $708.33 million, but each stock would be worth much more = $708.33 / 64.71 million stocks = $10.95. This represents a 34.36% increase with respect to the other alternative of investing the cash.

The issue here, is that this situation is not very realistic. It is not normal for a company to use all of its cash to repurchase stocks since it would result in a huge increase in stock prices (stock prices are set by supply and demand). Also, this would also result in a sharp increase in the cost of equity due to higher risks.