Assignment:
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.