Teardrop, Inc., wishes to expand its facilities. The company currently has 15 mi

Question

Teardrop, Inc., wishes to expand its facilities. The company currently has 15 million shares outstanding and no debt. The stock sells for $21 per share, but the book value per share is $10. Net income is currently $4.0 million. The new facility will cost $50 million, and it will increase net income by $660,000. Assume a constant price

Teardrop, Inc., wishes to expand its facilities. The company currently has 15 million shares outstanding and no debt. The stock sells for $21 per share, but the book value per share is $10. Net income is currently $4.0 million. The new facility will cost $50 million, and it will increase net income by $660,000. Assume a constant price

Explanation / Answer

SOLUTION:

Number of shares after the offering = 15 million + $50 million / $21 per share

Number of shares after the offering = $17,380,952.38

Since the par value per share is $1, the old book value of the shares is the current number of shares outstanding

New book value per share = (15 million * $10 + 2,380,952.38 * $21) / $17,380,952.38

New book value per share = $11.50

New EPS = $4.0 million / 15 million shares

New EPS = $0.26

The current P/E is $21 / 0.26 = $80.76

If the net income is increased by $660,000, the new EPS would be,

$15.66 million / $17,380,952.38 = $0.90 per share

Assuming the P/E remains constant.

The new stock price would be,

(P/E) * (New EPS) = $80.76 * $0.90

The new stock price = $72.68

The share price will increase from $21 to $72.68

The current market to book value is,

= $21 /$10 = 2.1

Current market to book ratio = 2.1

Using the new share price and book value per share, the new market to book ratio would be,

$72.68 / $11.50 = 6.32

The new market value of the firm would be,

NPV = -$50 million + (15.66 million * $72.68

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