Relationship among a Company’s Investments, Value, and Share Price

If a business can make an investment that generates more revenue than its opportunity cost of capital, the investment is beneficial to all parties involved and is, therefore, viable. An investment might reduce stakeholder value, i.e., it might generate less than a company’s opportunity cost of capital or perform below the hurdle rate. In such a case, a firm should put such funds to alternate use.

A measure of a company’s or business segment’s profitability in relation to the amount of capital invested by equity holders and debtholders is the return on invested capital (ROIC). It shows how successfully a company’s management can turn capital into operational profits after taxes.

It is calculated as:

$$ \text{ROIC}=\frac{\text{After-tax operating profit}}{\text{Average book value of invested capital}}$$

Where:

$$ \text{Invested capital} = \text{Common equity}+\text{Preferred equity}+\text{Debt} $$

Given that it is a source of income for lenders of debt capital, the cost of financing (such as interest expense), which is included in the denominator, is not expensed in the numerator. The related company cost of capital (COC), the required return employed in the NPV calculation, and the associated cost of funds of the firm are often compared with the ROIC metric.

If the ROIC metric is higher than the COC, a company is producing a higher return for investors than the required return, enhancing its (the firm’s) value for shareholders. The ROIC for the issuer will often surpass the COC, creating value for shareholders if management has made investments with a positive NPV and/or an IRR larger than its COC.

Example: Investment Effect on Company Value and Share Price

L.V. Solar Power’s present value of the future after-tax cash flows is estimated to be $125 million. L.V. Solar Power has 3 million outstanding shares with a market price of $22 per share. Upper management has just decided to invest in a new solar power plant in Kenya that will cost $98 million. The investment’s effect on the value of the company and its share price is:

$$\text{NPV of investment = \$125 million -\$98 million = \$27 million}$$

and

$$\text{Market value of the company prior to investment=\$3 million shares ×\$22=\$66 million}$$

The company’s value will increase from $27 million to $152 million, while the share price should increase from $22 to $31 per share.

$$\frac{\$27 \text{ million}}{3 \text{ million shares outstanding}} = $9 \text{ per share}$$

The NPVs of all future investments a corporation makes, considering potential externalities, are added to the value of its current investments to determine its overall worth.

Inflation impacts the capital allocation analysis of a corporation in a number of ways. The first is using “nominal” or “real” terms in investment analysis. Real cash flows are adjusted downward to take inflation into account, as opposed to nominal cash flows, which incorporate the impacts of inflation.

In addition, inflation reduces the value of depreciation tax savings to a company, effectively increasing its (the company’s) real taxes. Also, if inflation is higher than expected, the profitability of the investment is correspondingly lower than expected.

Question

The present value of Rocker Retailer’s future after-tax cash flow is estimated to be $25 million. Rocker Retailer has 1.2 million shares outstanding with a current market value of $4.5 per share. Rocker Retailer has just invested $23 million in a new store. The share price of Rocker Retailer after the investment is closest to:

1. $6.1.
2. $83.
3. $23.66.

The correct answer is A.

NPV of investment = $25 millon – $23 million = $2 million.

Market value of company before investment = $4.5 × 1.2 million shares = $5.4 million.

New company value = $5.4 million + $2 million = $7.4 million.

Value per share =  \(\frac{\$7.4 \ \text{million}}{\text{(1.2 million shares)}}\) = $6.1 per share.