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

Question

Teardrop, Inc.,wishes to expand its facilities. The company currently has 8 million shares outstanding and no debt. The stock sells for $65 per share, but the book value per share is $20. Net Income for Teardrop is currently $11.5 million. The new facility will cost $40 million, and it will increase net income by $600,000.

Assuming a constant price-earnings ratio, what will be the effect of issuing new equity to finance the investment? To answer this, calculate the 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? (explain in 2-3 sentences).

What would the new net income for Teardrop have to be for the stock price to remain unchanged?

Explanation / Answer

Hi,

Increase in profits =$ 600000

Current eps = 11500000/8000000

=$1.44

Current p/e ratio = 65/1.44

45.14

Company’s new net income = 12500000

New eps = 12500000/8000000

$1.56

Since p/e remains the same as 45.14, new price of share = (65/(11500000/8000000))*( 12500000/8000000)

=$70.65

Book value per share remains the same = $20

new market-to-book ratio = 70.65/20

3.53

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