Here is recent financial data on Pisa Construction, Inc: Stock price $40 Market
ID: 2670785 • Letter: H
Question
Here is recent financial data on Pisa Construction, Inc:Stock price $40
Market value of firm $400,000
Number of shares 10,000
Earnings per share $4
Book net worth $500,000
ROE 8%
Pisa has not performed spectacularly to date. However, it wishes to issue new shares to
obtain $80,000 to finance expansion into a promising market. Pisa’s financial advisers
think a stock issue is a poor choice because, among other reasons, “sale of stock a a price
below book value per share can only depress the stock price and decrease shareholder’s
wealth.” To prove they point the construct the following example: “Suppose 2,000 new
shares are issued at $40 and the proceeds are invested. (Neglect issue costs.) Suppose
return on investment does not change. Then:
Book net worth = $580,000
Total earnings = 0,08*(580,000) = $46,400
Earnings per share = 46,400 / 12,000 = $3,87
Thus, EPS declines, book value per share declines, and share price will decline as well to
$38,70.”
a) Evaluate this argument with particular attention to the assumptions implicit in the
numerical example.
b) What should be the rate of return from new project so as to make shareholders
indifferent between liquidation of company and issuance of new stock. Assume that
the book value of assets is equal to their market value and it is possible to issue shares
at $40 per share. Neglect issue cost.
Explanation / Answer
a) Expected rate of return on this stock is 10%. We know this, because stock price is $40 and Earnings per share are $4. That is why investing in a project that brings 8% is a value-destructing activity. The company should not undertake this investment because the rate of return is too small not because it would have to issue stock below book value. b) r = 25%. W then have: Total earnings = 0.08*$500,000+0.25*$80,000 = $60,000 Earnings per share = $60,000 / 12,000 = $5 Such earnings per share make share price increase to $50 so now shareholders are indifferent between liquidating the company to get $50 and receiving 10% annual return on the company.
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