Problem:
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 Return on investment 2% quarterly.
Pisa has not performed spectacularly to date. However, it wishes to issue new shares to obtain $100,000 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 at a price below book value per share can only depress the stock price and decrease shareholders’ wealth.” To prove the point they construct the following example: “Suppose 2,500 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 = $600,000
Total earnings = .0824(600,000) = $49,440
Thus, EPS declines, book value per share declines, and share price will decline proportionately to $38.40.”
Evaluate this argument with particular attention to the assumptions implicit in the numerical example.