3. It has been argued that you can analyze the impact on the stock price of any

Question

3. It has been argued that you can analyze the impact on the stock price of any capital structure or payout decision by looking at two factors.

a. What are these two factors and how do they effect the stock price?

b. In the light of the above answer, analyze the following capital structure changes:

i. A repurchase of equity financed with a new debt issue

ii. A new bond issue

iii. The repurchase of debt financed with a new equity issue.

c. What is wrong with the following statement: "It has been argued that the stock price declines as a result of a new stock issue because of dilution of the existing shares. That is, as you increase the number of shares earnings per share must decline since total earnings is divided by a larger number to get earnings per share."

Explanation / Answer

The two main factors which cause a change in the price of stock if the market is efficient are explained below.

EPS (Earnings per Share): EPS is referred as the return to the shareholders’, the change in EPS cause the change in the price of the stock, because the price of a stock is determined by the future earnings from the stock. The more earnings will result in a higher price of a stock.

P/E ratio: The price to earnings ratio indicates the future earnings capability of firm, the higher ratio indicates the future prospects of firm are bright and firm’s earnings will be attractive. The higher ratio results in a higher price of a stock.

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