Teardrop Inc. wishes to expand its facilities. The company currently has 8 milli

Question

Teardrop Inc. wishes to expand its facilities. The company currently has 8 million shares outstanding and no debt. The stock sells for $50 per share, but the book value per share is $18. Net income is currently $17 million. The new facility will cost $35 million and it will increase net income by $1.1 million. a. Assuming a constant price-earnings ratio, what will the effect be of issuing new equity to finance the investment? To answer, calculate the new book value per share, the new total earnings, the new EPS, the new stock price, and the new market-to-book ratio. What is going on here? b. What would the new net income for the company have to be for the stock price to remain unchanged?

Explanation / Answer

Current P/E ratio = Market price per share * Shares outstanding / Net income = 50 * 8 / 17 = 23.53 New net income = 17 + 1.1 = $18.1 million Shares would be issued at its current book value. Hence the new number of shares issued = 35 million / 18 = 1.94 million Total shares outstanding = 8 + 1.94 = 9.94 million New book value = (Present book value per share * current # of shares + value of asset ) / new # of shares = (18 * 8 + 35) / 9.94 = $18.01 per share New EPS = Earnings / # of shares outstanding = 18.1 / 9.94 = $1.82 Assuming a constant P/E ratio, market price of the share = P/E ratio * EPS = 23.53 * 1.82 = $42.85 New market to book ratio = 42.85 / 18.01 = 2.38 The result of issuing new equity is an increase in book value per share, decrease in market price, decrease in EPS and decrease in market to book ratio. For the stock price to remain unchanged, new EPS = P/E ratio / price = 23.53 / 50 = $0.47 per share New net earnings = New EPS * # shares of outstanding = 0.47 * 9.94 = $4.68 million

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