"Corporate Finance": cannibalization
When a new project reduces the cash flows of an existing project of the same firm, it is best described as a(n):
A、 sunk cost.
B、 opportunity cost.
A company has 100 million shares outstanding. The share price of a company’s stock is £15 just prior to announcing a £100 million expansionary investment in a new plant, and the company estimates that the present value of future aftertax cash flows will be £150 million. Analysts, however, estimate that the new plant’s profitability will be lower than the company’s expectations. The company’s stock price will most likely:
A、 drop below £15 per share due to the cannibalization of revenue from the new plant.
B、 increase by less than £0.50 per share.
C、 increase by the new plant’s net present value per share.
C is correct. A new project reducing the cash flows of an existing project is an externality called cannibalization.
A is incorrect because it is an example of cannibalization and not a sunk cost.
B is incorrect because it is an example of cannibalization and not an opportunity cost.
B is correct. The value of a company is the value of its existing investments plus the net present values of all of its future investments. The NPV of this new plant is £150 million – £100 million = £50 million. The price per share should increase by NPV per share or £50 million/100 million shares = £0.50 per share. As the new plant’s profitability is less than expectations, the NPV per share (and hence the increase in the stock price) should therefore be slightly below £0.50 per share.
A is incorrect. It is only new plant’s profitability that is below the average not the overall. The company value should not fall below £15 per share, all things being equal.
C is incorrect. See the above calculation.